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EconomicsMarketsStrategy3Q 2013DBS Group Research13 June 2013

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June 13, 2013Economics–Markets–Strategy

Singapore

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The information herein is published by DBS Bank Ltd (the “Company”). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof. The infor-mation herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.

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ContentsIntroduction 4

Economics How high the moon? 6

Currencies Looking past volatility 22

Yield Transitioning to higher interest rates 36

Offshore CNH Becoming a global player 52

Asia Equity Wary but hopeful 56

Greater China, Korea

China A paradigm shift in macro management 68

Hong Kong More inflation 72

Taiwan Recovery is delayed 78

Korea Not too weak 84

Southeast Asia, India

India Stuck in negative loop 88

Indonesia Commodity headwinds 94

Malaysia Expectation lowered 98

Thailand Infrastructure push 104

Singapore Not as bad 108

Philippines Fastest 114

Vietnam Turning dicey again 118

G3

United States comme ci, comme ca 122

Japan Is the party over? 126

Eurozone No easy way out 132

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Economics–Markets–StrategyJune 13, 2013

Economic forecasts

Policy and exchange rate forecasts

Policy interest rates, eop Exchange rates, eop

current 3Q13 4Q13 1Q14 2Q14 current 3Q13 4Q13 1Q14 2Q14

US 0.25 0.25 0.25 0.25 0.25 … … … … …Japan 0.10 0.10 0.10 0.10 0.10 94.7 100 102 104 105Eurozone 0.50 0.50 0.50 0.50 0.50 1.336 1.31 1.32 1.34 1.35

Indonesia 5.75 5.75 5.75 6.00 6.25 9,893 9,850 9,800 9,750 9,700Malaysia 3.00 3.00 3.00 3.00 3.00 3.15 3.02 2.99 2.96 2.94Philippines 3.50 3.50 3.50 3.75 4.00 43.1 41.5 41.0 40.5 40.0Singapore n.a. n.a. n.a. n.a. n.a. 1.26 1.24 1.23 1.21 1.19Thailand 2.50 2.50 2.50 2.50 2.75 31.0 29.9 29.8 29.7 29.6Vietnam^ 7.00 7.00 7.00 7.00 7.00 21,031 21,100 21,200 21,300 21,400

China* 6.00 6.00 6.25 6.25 6.50 6.14 6.09 6.06 6.03 6.00Hong Kong n.a. n.a. n.a. n.a. n.a. 7.77 7.77 7.78 7.79 7.80Taiwan 1.88 1.88 1.88 2.00 2.13 29.9 29.6 29.4 29.2 28.9Korea 2.50 2.50 2.50 2.75 2.75 1135 1100 1080 1060 1040

India 7.25 7.00 7.00 7.00 7.00 58.2 56.2 56.6 57.0 57.4

^ prime rate; * 1-yr lending rate

Source: Bloomberg and DBS Group Research

GDP growth, % YoY CPI inflation, % YoY

2010 2011 2012 2013f 2014f 2010 2011 2012 2013f 2014f

US 3.0 1.8 2.2 1.6 2.2 1.6 3.1 2.1 1.6 2.0Japan 4.5 -0.6 2.0 1.8 0.9 -0.7 -0.3 0.0 0.0 2.0Eurozone 1.9 1.6 -0.5 -0.6 0.1 1.6 2.7 2.5 1.5 1.9

Indonesia 6.1 6.5 6.2 6.3 6.5 5.1 5.4 4.3 5.3 5.4Malaysia 7.2 5.1 5.6 5.0 5.5 1.7 3.2 1.7 2.0 2.4Philippines 7.3 3.6 6.8 6.4 6.0 3.8 4.8 3.1 3.1 4.0Singapore 14.8 5.2 1.3 2.5 4.0 2.8 5.2 4.6 2.8 3.6Thailand 7.8 0.1 6.4 5.0 5.0 3.3 3.8 3.0 2.9 3.7Vietnam 6.8 5.9 5.0 5.3 5.7 9.2 18.6 9.3 6.7 6.8

China 10.3 9.3 7.8 8.0 8.5 3.3 5.4 2.6 3.5 3.5Hong Kong 7.0 4.9 1.5 4.0 4.0 2.4 5.3 4.1 4.5 3.5Taiwan 10.7 4.1 1.3 2.6 4.2 1.0 1.4 1.9 1.0 1.3Korea 6.2 3.6 2.0 2.8 4.0 2.9 4.0 2.2 1.5 2.9

India* 8.4 6.5 5.0 5.7 6.1 9.6 8.9 7.4 6.7 7.0

* India data & forecasts refer to fiscal years beginning April; inflation is WPI

Source: CEIC and DBS Research

3


Interest Rate Forecasts%, eop, govt bond yield for 2Y and 10Y, spread in bps

Source: Bloomberg and DBS Group Research

12-Jun-13 3Q13 4Q13 1Q14 2Q14US 3m Libor 0.27 0.30 0.30 0.30 0.30

2Y 0.33 0.78 0.78 1.17 1.1710Y 2.23 2.75 3.00 3.25 3.5010Y-2Y 190 197 222 208 233

Japan 3m Tibor 0.23 0.25 0.25 0.25 0.25

Eurozone 3m Euribor 0.21 0.19 0.19 0.19 0.19

Indonesia 3m Jibor 5.16 5.50 5.75 6.00 6.252Y 5.78 5.50 6.00 6.50 6.7510Y 6.51 7.00 7.50 8.00 8.2510Y-2Y 74 150 150 150 150

Malaysia 3m Klibor 3.21 3.25 3.25 3.25 3.253Y 3.15 3.20 3.20 3.20 3.2010Y 3.46 3.60 3.60 3.60 3.6010Y-3Y 31 40 40 40 40

Philippines 3m PHP ref rate 1.55 1.50 2.00 2.75 3.002Y 2.72 2.75 3.00 3.25 3.5010Y 3.54 4.25 4.50 4.75 5.0010Y-2Y 82 150 150 150 150

Singapore 3m Sibor 0.37 0.35 0.35 0.35 0.352Y 0.28 0.40 0.40 0.46 0.4610Y 2.19 2.10 2.25 2.35 2.5010Y-2Y 191 170 185 189 204

Thailand 3m Bibor 2.60 2.60 2.60 2.60 2.852Y 2.83 2.70 3.00 3.00 3.2510Y 3.97 3.80 4.25 4.25 4.5010Y-2Y 114 110 125 125 125

China 1 yr Lending rate 6.00 6.00 6.25 6.25 6.502Y 3.09 3.25 3.50 3.75 3.7510Y 3.46 3.75 4.00 4.25 4.2510Y-2Y 37 50 50 50 50

Hong Kong 3m Hibor 0.38 0.40 0.40 0.40 0.402Y 0.25 0.83 0.93 1.32 1.3210Y 1.62 2.10 2.60 2.85 3.1010Y-2Y 137 127 167 153 178

Taiwan 3M CP 0.88 0.80 0.80 0.88 1.002Y 0.61 0.80 0.90 0.90 0.9010Y 1.34 1.60 1.70 1.70 1.7010Y-2Y 73 80 80 80 80

Korea 3m CD 2.69 2.70 2.75 3.05 3.053Y 2.88 2.85 3.00 3.25 3.5010Y 3.31 3.50 3.75 4.00 4.2510Y-3Y 43 65 75 75 75

India 3m Mibor 8.46 8.00 8.00 8.00 8.002Y 7.41 7.00 7.00 7.00 7.0010Y 7.30 7.50 7.50 7.50 7.5010Y-2Y -11 50 50 50 50

4

Economics–Markets–StrategyIntroduction

Global growth remains in the doldrums. US growth has averaged but 1.4% annualized for the past two quarters, considerably less than the 2.2% averaged in the two quarters before that. We expect further slowing to 1.2% in 2Q13, thanks mainly to the $85bn of sequester cuts that take effect in the six months between April and September.

What’s $85bn over six months? A lot. Here’s one way to see it. Start with the $16trn economy. That’s an annualized number, which means output is $4trn per quarter. Next, pretend growth runs at a 2% rate – what it’s done for the past two years. Add in another 2% for inflation and nominal GDP growth comes to 4%. Again, though, that’s an annualized 4 percent. So you’re looking at 2% actual growth over six months’ time. Two percent of $4trn comes to $80bn, a tad less than the $85bn of sequester cuts.

In other words, the $85bn of sequester cuts more than wipe out all the growth one might have expected / enjoyed had the economy continued to chug along at the 2% real rate that it has for the past two years. That is what $85bn in six months is. And what it means is that growth over the next two quarters isn’t going to look much better than it has for the past two. Expect about 1.4% – less than half the long-run average.

Europe of course is faring more poorly than the US. Growth there isn’t running at 50% to 60% of long-run average. The economy there has been shrinking for the past six quarters. Granted, it shrank at only a 1% annualized rate in the first quarter, much better than 2.4% contraction in 4Q12. But few are convinced the ‘improvement’ is anything but volatility. The PMIs remain well below 50 (chart below). The unemployment rate marches relentlessly northward. It’s now at 12.2% for the Eurozone overall. In France, unemployment has breached 11%; in Italy, 12%. In Spain it is only two ticks shy of 27%, about where Greece is, of all places. The pain has become so acute that national authorities are now, with official blessing from the EU and the IMF, backing away from the austerity plans

David Carbon • (65) 6878-9548 • [email protected]

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Slowboat to everywhere

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IntroductionEconomics–Markets–Strategy

agreed to in 2011 and 2012. The ECB’s OMT program has done a marvelous job of keeping speculators off the back of the euro and sovereign bonds but, as the recent rate shows, it has done nothing to help the real economy. Short-term threats to the euro are low; longer-term risks emanating from the real economy remain essentially unchanged.

In Asia, China is key. The new leadership has made it abundantly clear it is in no hurry pick up the growth pace. Longer-term structural changes and reforms are the priority for now – not lifting the short-term cyclical growth rate with government sponsored fixed asset investment.

That’s fine, even good, if it lessens the risk of a cyclical blowout somewhere down the line. Steady growth is, or should be, the preference for investors of all stripes. More predictability, less risk, a better night’s sleep. There’s plenty of investment coming down the pipe, what with plans for increased urbanization on the drawing board and the pressing need to bring development inland and away from the coast.

We had been anticipating a bit more gas from China once the new leadership took over at the start of the year. With no urgency being displayed there, we have downgraded our growth forecast to 8% from 9% and, if Beijing remains as nonchalant as it has been so far this year, that could fall further.

China, the US and Europe. Three speeds. Three attitudes. Europe is shrinking and authorities are anxiously loosening fiscal policy. The US is plodding along at a sub-2% pace and the Fed is debating whether to begin trimming QE3. China is running much faster than anywhere else in the world but much slower than recent norms and the authorities appear pleased as punch.

A slowboat to everywhere. When the global financial crisis erupted in earnest back in 2008, isn’t this precisely where everyone said we would be five years hence? When you think about it, things could be a lot worse.

David Carbon, for

DBS Group Research

June 13, 2013

6

Economics–Markets–StrategyEconomics

Global central banks continue their drive to push interest rates lower. US short-term rates have been zero for four years and while markets fret the eventual tapering of QE3, for now the Fed continues to buy $85bn of Treasury and mortgage bonds every month. The ECB cut rates to 0.5% in May and its balance sheet now stands at 30% of GDP, 10 percentage points higher than the Fed’s. Enter Japan! The central bank there has announced it will double the size of the monetary base in the next two years.

Money, money, money. A lot of it’s being printed and a lot of it doesn’t stay put – it flows to Asia, where growth and returns are higher. Interest rates fall, asset prices rise – especially property, the most interest rate-sensitive asset of all. Since March 2009, when the global financial crisis ended in Asia, residential property prices have


ECO

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Asia property: how high the moon?

• Asia’s property prices march relentlessly northward

• Relative to incomes, however, prices are falling steadily in most Asian countries. Housing is becoming more affordable, not more expensive

• Hong Kong is the key exception to this rule. Property prices relative to income have risen by nearly 80% since 2000. This raises a red flag

• Housing debt remains very low in Asia compared to the US

• But when interest rates go up, risks go up. Monthly housing payments in many Asian countries will rise by 15%-25% when rates return to precrisis norms. Some families will find themselves over-extended

• Indonesia and the Philippines are the most vulnerable to higher interest rates. China, India and Thailand are the least vulnerable

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Economics Economics–Markets–Strategy

more than doubled in Hong Kong. They’re up by 55% in Singapore, 50% in China and Taiwan and by 40% in Malaysia (chart below).

For foreign investors lucky enough to have bought back in 2009, returns have been 20-50 percentage points higher in USD terms, thanks to inflows pushing currencies north in tandem with property. Unable to control these inflows and local interest rates as a result, authorities throughout Asia have resorted to direct / administrative controls on property to keep prices in check. And still they rise. Compared to March 2000, prices in Asia now are as high as they were in the US just before the eruption of the subprime crisis that threw the entire global economy into the biggest recession since 1929 (chart bottom of previous page).

How high the moon?

How much higher can Asia’s property prices go? Have they risen ‘too far’ already? If so, can GDP/income growth restore a proper balance? Or has a bubble formed that only a blowout can now ‘fix’?

Let’s answer the last question first, or, rather, ‘address’ it. Because nobody we know of has ever come up with a way to identify a bubble until after it’s blown. If

Capital inflow turned briefly to outflow in late-2011. Inflows are the rule again

Hong Kong’s property prices have risen the most since 2009. Singapore’s next

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From an invest-ment perspective, property prices do not appear out of line with equities in Hong Kong

monetary authorities could do it, bubbles wouldn’t exist. If private investors could do it, they wouldn’t be sitting in your office professing such skill, they’d be sitting on the beach or advising kings and presidents. The best one can do is to look hard at the data and make inferences about what comes next. Let’s try that.

Housing as an investment

While most people buy homes to live in, many in Asia buy them as investments. Often, they are blamed for driving house prices higher than they ‘should’ be. Singapore and Hong Kong are home to Asia’s wealthiest investors and highest home prices. Is there a connection? More generally, from an investment return perspective, how have home prices compared to, say, equities?

In Hong Kong (chart above), equities and property have offered similar returns over the long haul. Since 1985, equities have risen by 10.6% per year, a tad more than the 9.8% return delivered by property. Rental payments and equity dividends are missing from this picture but assuming they are broadly similar then the conclusion wouldn’t change: from an investment point of view, property does not appear overvalued relative to equities.

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Ditto for Singa-pore

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A small (100 sq meter) home would cost US$1.4mn in Hong Kong and US$870k in Singa-pore

Ditto for Singapore (chart at bottom of previous page). In USD terms, (to make returns comparable with Hong Kong), both property and equities have returned 8.1% per year since 1985. Assuming again that rental payments and equity dividends are similar, then like Hong Kong, Singapore property prices do not appear overvalued relative to equities.

As long as we have these long-run pictures in front of us, it’s worth making a couple of additional points. The first regards Hong Kong, and the fact property prices there have climbed so much more in recent years than in other countries. It seems reasonable to view much of Hong Kong’s rise as a rebound from the SARS epidemic that peaked in mid-03. Yes, prices have soared by 4x since then but compared to 1997, they are up by only 40%. Moreover, from a purely technical / price perspective, 1997 does not appear overvalued looking back over the data today.

Similarly for Singapore. It is often exclaimed that property prices (and rents) have soared of late. And they are, in fact, up by 55% since mid-09. But that puts them only 18% higher than 1996 levels. Of course one could argue that Singapore’s prices were ‘too high’ in 1996. To some extent we’d agree. But deflate the 1996 levels to something ‘more reasonable’ and today’s prices still don’t seem out of line with what prevailed 17 years ago.

How much is that house in the window?

Price changes are one thing. What about prices themselves – the levels? How much does a house cost in Chinese yuan, or Indonesian rupiah or Sing dollars? And can anyone afford to buy one anymore?

Asia’s houses aren’t cheap, that’s for sure. The average 100 sq meter (1055 sq ft) home in Hong Kong would run you US$1.4 million today. And that’s not a big house, either, even by Asian standards. But it’s already so expensive that the average family in Hong Kong lives in a 60 sq meter house instead. That’s barely one-quarter the average US home size (208 sq m / 2200 sq ft).

Prices are lower in Singapore but the average 100 sq meter home will still run you US$870k. In Taipei, 100 sq meters costs half a million USD and in Bangkok, $180k.

Average home sizessq m sq ft

Thailand (Bkok) 50 528Hong Kong 60 633Singapore 100 1,055Taiwan (Taipei) 105 1,108China 120 1,266Malaysia 130 1,372Japan 130 1,372US 208 2,194

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In spite of all the hoopla, China is still cheap. A 100 sq m home costs less than $100k. A bargain at twice the price? Perhaps. But much of the apparent economy owes to the China figure being a national average. A home in Beijing or Shanghai would cost 3 times more. That’s still cheap compared to Taipei, HK or Singapore and only 30% more expensive than Bangkok. By this gauge, China doesn’t appear overpriced at all. Homes are still cheapest in Malaysia ($42k per 100 sq m) and the US ($85k), where land is abundant. Again, though, these are national prices; houses in Kuala Lumpur or New York City would cost 2.5x-4x more.

How many years to buy a house?

Numbers are just numbers until you put them next to something, like wages or income. How many years do you have to spend behind a desk in Singapore or Bangkok before you can buy one of these houses? That’s the ‘real’ price of a home (and one measure of the ‘real’ wage).

We’ve already seen that Hong Kong’s houses are by far the most expensive in Asia in nominal dollar terms. But the gap is even wider in real terms. In Hong Kong, it takes almost 40 years for the average person to buy the average 100 sq m house. That’s 2.5x longer than it takes in China. And here, measures are not being distorted by national averages. Prices in Shanghai may be three times the national average but so are wages. Hong Kongers really do have to work 2.5x longer than they do in China before they can buy that 100 sq m home.

This puts a whole new spin on ‘real’ income. Hong Kong is purported to be far richer than China, and most other places in the world. But in terms of houses/housing, Hong Kong’s ‘real’ wages are 2.5x lower than China’s!

Elsewhere in Asia, ‘real’ wages in housing terms are comparable to China’s. It takes the same number of years (15) for the average Singaporean to buy a 100 sq m home. Ditto for Thailand. Prices are cheaper (real incomes are higher) in Taiwan, where it takes only 9 years to buy a home. Incomes are higher yet in Malaysia (4 years to buy a home) and the US (1.7 years).

Housing compression

It comes as no surprise that where housing is expensive, people live in smaller houses, and vice-versa. In Hong Kong, where it takes 40 years to buy a 100 sq m home, people live in 60 sq m homes instead. In Singapore and Taipei, the norm is in fact 100 sq m. In Malaysia, where houses are cheaper, people opt for 130 sq m homes. And in the US, where housing is the cheapest of all, 208 sq m is the norm.

It takes 39 years for the aver-age Hong Kong resident to earn enough to buy a 100 sq meter home

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When you recalculate how many years of work it takes to buy what people actually buy, the expenditure range gets compressed. At the high end, Hong Kong’s number shrinks to 23 years from 39; at the bottom end, the US number stretches to 3.5 years from 1.7. But it’s still a wide range and it begs an immediate question.

Real home prices as a bubble gauge

If Hong Kong’s house prices are so high, and US prices are so low, why did the biggest housing collapse in 100 years occur in the US and not in Hong Kong? Plainly, something’s missing – housing prices alone, either in nominal or ‘real’ terms, tell us nothing about what’s about to blow. That hurts. If you can’t compare Hong Kong or Singapore to Thailand or the US, how do you get a feel for risk?

You do the only thing left: compare Singapore today with Singapore yesterday, Thailand today with Thailand yesterday, and so on. Let’s start with Asia overall. We began this report by showing a chart of Asian property prices – reproduced below left for convenience – rising to US crisis levels and asked if Asia might be headed for a crash too. Deflating prices by incomes – chart below right – the answer would seem to be ‘no’. Asia’s home prices have risen rapidly since 2000 but incomes have risen even faster [1]. Today, home prices are 22% lower, relative to incomes, than

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If takes 39 years to buy a 100 sq meter home in Hong Kong and only 1.7 years in the US ....

... then why did the US blow and not HK?

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they were they were back in 2000. By this gauge, Asia has little to fear on the property front – homes are becoming more affordable, not more expensive.

Importantly, this is true for most individual countries, not just for the average. In China, where so much attention has been paid to the property sector, incomes have risen almost twice as fast as prices since 2000. Homes are 40% cheaper, relative to incomes, than 13 years ago. Even in more recent years, China’s price:income ratio has run sideways, not upward.

In Singapore, price:income ratios have drifted upward a little bit since 2006 or 2009 but not by very much. Prices are 10% higher than they were in 2006, but they are 15% lower than they were in 2000. In the 5 years since 2007, prices have essentially run parallel to incomes.

The same is true for Korea, Thailand and Malaysia. In Korea and Thailand, prices (relative to income) have drifted south steadily over the past decade. In Malaysia, they are lower than they were back in 2000, and essentially unchanged from 2007 or 2009 levels.

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00 02 04 06 08 10 12 14

HK – house price to income ratio


USA

HongKong

0.60

0.80

1.00

1.20

1.40

1.60

00 02 04 06 08 10 12 14

Taiwan – house price to income ratio


USA

Taiwan

Asia’s exceptions are Taiwan and Hong Kong. Taiwan’s prices (relative to income) have risen by 20% since 2000. That’s not insignificant. But it’s still far less than the jump in the US just before the subprime crisis there. US prices rose by 50%, relative to incomes, in the six short years between 2000 and mid-2006.

The situation is more serious in Hong Kong. There, prices are up by 78%, relative to incomes, compared to 2000 levels. When affordability drops so far so fast, something needs to be looked at.

The first thing to check is whether 2000 is a good base year for comparison. If one takes a longer-term view, for example, does the picture change?

The answer is, yes to some degree. Prices (relative to incomes) today are no higher than they were in 1997 and not much higher than what prevailed for the six years between 1991-1997. One could argue that the Asian financial crisis of 1997 brought prices down to where they “ought to be”. But that’s too simplistic. The Asian financial crisis was not about Hong Kong (or Singapore). It was about Thailand, in the first instance, and then Malaysia, Indonesia and Korea. The drop in currencies values and asset prices in Singapore, Hong Kong and Taiwan was collateral damage – spillover from the “Crisis-4” countries. Hong Kong, Singapore and Taiwan weren’t the center of anybody’s attention.

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Hong Kong and Singapore – house price to income ratio

1985=1.00, price to per cap GDP ratio, annual avg data

Hong Kong

Singapore

HK prices relative to income are up by nearly 80% since 2000. That raises concerns

14


The question remains: were prices in Hong Kong too high in 1997 (on the cusp of the Asian financial crisis) or too low in 2003 (at the peak of the SARS epidemic)? Mostly the latter, we think, but housing there is still among the most expensive in the world, in absolute terms and relative to income. Home ownership rates for residents are only 52% compared to Singapore’s 90%, a fact that is surely related to affordability and probably to a less equal income distribution as well. Thus, while from a financial market perspective, Hong Kong’s housing situation is probably not best described as a bubble, social tension related to housing affordability appears to be on the rise.

Leverage

Housing risk isn’t necessarily about prices per se. In the US, the bigger problem was the underlying build up of leverage and debt, which ultimately could not be sustained. How does Asia look from a debt perspective? How burdensome are housing payments today and how burdensome might they become once interest rates start to rise? Who in Asia is most vulnerable to a potential ‘interest rate shock’?

Asia’s housing debt as a percentage of income has risen steadily over the years. For the most part, that’s normal. Housing is a ‘superior’ good. As incomes go up, housing expenditures tend to go up even more. The fact that housing debt, even as a percentage of income, is rising across the region is not, by itself, cause for alarm. As always, it’s a question of ‘how far how fast’ and whether the debt can be serviced in bad times as well as good.

In Singapore and Hong Kong, Asia’s richest countries, housing loans have grown to about 45% of GDP (chart below left). Singapore’s debt has clearly grown faster than Hong Kong’s but Singapore’s per capita income has grown faster too. Back in 1967, both countries had a per capita income of US$5200 (at today’s prices and exchange rates). Today, Singapore’s GDP per capita is US$57k, 50% higher than Hong Kong’s US$38k.

Debt has risen steadily in China and Korea too (chart below right; same X and Y scale as for SG and HK on the left), though it’s much lower than in the wealthier economies. China’s debt load is about half as large as Korea’s; Korea’s is two-thirds as large as Singapore’s and Hong Kong’s.

Debt loads and per-capita incomes of other countries are shown in the chart at the top of the next page. Beyond illustrating the ‘superior good’ aspect of housing across countries, the key message of this chart is that US housing debt, even 5 years after the crisis, still stands at 85% of GDP – nearly twice as high Singapore, Hong

Leverage and debt are what did the US in, not prices per se

0

10

20

30

40

50

60

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Singapore

Financial sector housing loans as % of GDP

SG & HK – housing debt as % of GDP

Hong Kong

0

10

20

30

40

50

60

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

CH & KR – housing debt as % of GDP

Financial sector housing loans as % of GDP

China

Korea

Data unavailable, scaling with chartat left maintained

15


Kong and Taiwan, and 3x to 5x higher than other Asian countries.

High debt / leverage is what caused the US bubble and its collapse. When interest rates rose – Fed funds rose by 425 basis points between mid-04 and mid-06 – borrowers found it increasingly difficult to service their debts. By mid-06, the jig was up. Home prices began to fall. Banks would not / could not extend refinancing. The value of mortgage backed securities plummeted. Companies that couldn’t possibly insure against such losses but did anyway went broke. The rest is (not yet) history.

For Asia, the good news part of the story above is that regional debt loads remain far lower than they were in the US. It is not unreasonable to conclude that risks in Asia are lower accordingly.

Debt burdens and interest rates

Debt loads aren’t a big problem when interest rates are zero. (“Roll it over Joe, and call me next year.”) It’s when you can’t make the payments that trouble begins and what used to be a hidden bubble isn’t so hidden anymore. How burdensome are Asia’s housing payments today and who will be in trouble when today’s rock-bottom rates start to go up?

0.3 0.3

0.7

1.4 1.51.8

2.3 2.52.7 2.8 2.9

5.4

0

1

2

3

4

5

6

PH ID IN CH JP TH KR MY SG HK TW US

Housing debt payments as % of GDP

interest + principal payments as a % of GDP, 20Y payback assumed

Asia’s debt loads are very low com-pared to the US. That’s a relief

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0

10

20

30

40

50

60

70

80

90

PH ID IN CH TH MY KR HK SG TW US

Housing loans as % ofGDP (LHS)

Per-capita income in2012 USD (RHS)

Housing debt and income level

percent US dollars per person

16


To answer the first question, we calculate the annual payment required to retire the stock of outstanding housing loans in each country, at the prevailing interest rate [2] and subject to the condition that principal and interest are re-paid in full over the next 20 years.

Who’s got Asia’s biggest payments? By this gauge, it turns out to be Taiwan, where 2.9% of GDP goes to pay housing principal and interest (chart at bottom of previous page). But Hong Kong and Singapore are almost identical, paying 2.8% and 2.7% of GDP to service housing debt each year. Malaysia’s and Korea’s burdens are in the low 2 percent range. Thailand’s burden is an even lower 1.8% of GDP.

Where does China fall on this ladder? Near the bottom with annual housing payments of only 1.4% of GDP.

Worry? It wouldn’t seem so. Especially when one compares Asia’s debt burdens with the US. There, payments are running at 5.4% of GDP, nearly 6x higher than in China, and 2x higher than in Hong Kong, Singapore and Taiwan.

Again, this has to be good news for Asia. The US seems to have blown for a reason and, for the same reason, Asia seems unlikely to.

When rates go up

Risks remain. Interest rates have been on the floor for 5 years. What’s going to happen when they go back up? Who’s vulnerable in Asia?

The simplest way to answer this question is to re-calculate the housing payments made above under the new assumption that interest rates have returned to their pre-crisis level. Who suffers most will depend partly on debt loads and partly on whose interest rates fell the most and will now rise the most.

The key variables behind these calculations are shown in the table below. It comes as no surprise that interest rates in Singapore and Hong Kong have fallen comparatively the most in Asia – by a factor of 2x to 2.1x (col 5). Singapore and Hong Kong run currency pegs, which means their interest rates track US rates (in the case of HK) or a basket of US, EU and JP rates (in the case of Singapore). In all instances, these rates are near zero.

Who's vulnerable to higher interest rates?

(1) (2) (3) (4) (5) (6) (7) (8) (9)=(4)/(3) =(7)/(6)

Housing Housing Mtge Mtge Annual Annualloans loans rate rate amortiz'n amortiz'n

to GDP current pre-crisis* Ratio current hypo** Ratio GDPUSD bn % % % x USD bn USD bn x USD bn

China 1,404 16 5.8 5.3 0.9 120 115 0.96 8,632

HK 120 45 2.2 4.6 2.1 7.5 9 1.25 266Spore 129 46 1.6 3.2 2.0 7.6 8.9 1.16 283

Korea 368 31 4.1 6.5 1.6 27 33 1.23 1,187Taiwan 230 48 2.0 3.5 1.8 14 16 1.15 482

Malay 98 32 4.6 4.4 1.0 7.6 7.4 0.98 309Thai 78 20 6.2 5.3 0.8 6.9 6.4 0.93 388

Indon 22 2.6 10.0 14.6 1.5 2.6 3.5 1.33 864Phils 6.8 2.6 7.6 12.5 1.7 0.67 0.93 1.40 264

India 137 7.3 8.1 6.8 0.8 14 13 0.91 1,875

US 13,137 83 2.6 5.1 1.9 851 1,061 1.25 15,810Japan 1,194 23 2.6 3.0 1.1 77 80 1.04 5,152

* 8Y average from 2000-2007.** based on LR interest rate in Col 4

When interest rates go back up, risks will too

17


The situation is different in Malaysia. There, rates are not much different from pre-crisis levels and the risk of interest rate shock seems low. In China, interest rates are higher today than they were on average before the crisis. Theoretically, a return to precrisis rates would be a pleasure, not a pain.

A doubling of interest rates of course does not imply a doubling of one’s monthly payment because most of what is being repaid is principal, not interest. Therefore, while Singapore and Hong Kong interest rates might rise comparatively the most in Asia, it does not follow that the risk to their economies is greatest.

In fact, by our gauge, Indonesia and the Philippines will experience Asia’s largest jump in housing payments when interest rates return to precrisis norms. This follows partly from a large interest rate differential (1.5x to 1.7x) and partly from the fact that interest rates there are so much higher than in other countries in absolute terms. A 50% increase in Indonesian interest rates, for example, implies a 460 basis point rise. That’s a serious move.

A return to precrisis mortgage rates would raise annual housing payments in the Philippines by about 40% (column 8 in the table on the previous page) and raise Indonesia’s by about one-third. That might not be a crushing blow but a 30%-40% increase in monthly housing payments would not come easily to most households.

Payments in Singapore and Hong Kong would be relatively easier to manage. Nevertheless, a rise in mortgage rates to precrisis averages (a doubling in these two cases) would, by our measure, bring a 25% increase in monthly payments in Hong Kong and a 16% monthly increase in Singapore. As in the Philippines and Indonesia, these increases could probably be absorbed in most cases. But it seems equally likely that some families would find themselves over-extended.

The vulnerability of other countries to higher interest rates is shown in the chart below. Most countries in Asia will, by our measure, face increases of 15% to 25% in housing payments when interest rates return to precrisis norms. China, Malaysia, Thailand and India are the clear exceptions. These countries have not experienced large falls in interest rates and presumably would not suffer (direct) shocks when global interest rates return to precrisis norms.

The US remains an interesting case. Mortgage rates there have fallen to 2.6%, about half their precrisis norms, thanks to QE3 / Fed purchases of mortgage bonds, which continue to run at a pace of $40bn per month. In recent weeks, markets have come to believe the Fed will need to taper back these purchases in the near future.

40

33

25 2523

16 15

4

-2-4

-7-10

0

10

20

30

40

50

PH ID US HK KR SG TW JP MY CH TH IN

Who's vulnerable to higher interest rates?

% increase in housing payments if interest rates return to precrisis avg

more vulnerable

less vulnerable

Monthly housing payments in many countries will rise by 15%-25%. Some families will find themselves over-extended

Indonesia and the Philippines are the most vulnerable to higher interest rates. China, India and Thailand are least vulnerable

18


But if the result is that average monthly mortgage payments go up by 25%, as our calculations suggest, the improvement seen in the housing sector over the past year could come to an abrupt halt. The Fed could find itself back at Square One, faced with what might have been an obvious fact all along: that if you truly are driving the economy, as many believe, you can’t simply stop. Time will tell but the numbers here suggest the US is every bit as vulnerable to higher interest rates as Asia is.

In sum

When economies get over-extended, property is almost always at the center of the trouble. Property brought down Asia in 1997. Property brought down the US – and the rest of the world – in 2007/08. Recovery is not complete. Risks remain. Interest rates are still near zero in the G3 and parts of Asia. Low rates and capital flows are pumping up property sectors in Asia and the eventual return of interest rates to normal levels could reveal some households and countries as having become over-extended.

To summarize what we’ve shown above:

1) Returns on property have been nearly identical to equity market returns over the long-haul in Singapore and Hong Kong. From an investment perspective, property does not appear over-valued compared to the key alternative;

2) Although prices have more than doubled in Hong Kong since 2009 and are up by 55% in Singapore, they are up by only 40% and 18% compared to 1997 levels. Moreover, 1997 prices do not appear overvalued by much, if at all;

3) Asia’s houses are expensive. A 100 sq meter home costs US$1.4mn in Hong Kong and US$870k in Singapore. Houses are cheap in China ($97k / 100 sqm), the US ($85k) and Malaysia ($42k);

4) It takes the average Hong Kong resident 39 years to earn enough to buy a 100 sq meter home. In China, Singapore and Thailand, it takes 13-15 years. In the US, it takes 1.7 years;

5) US houses are extremely cheap compared to Asia. Yet it was a US bubble that led to the biggest global recession in 100 years. Conclusion? Prices per se tell us nothing about risk;

6) Although Asia’s home prices are high, they have fallen steadily relative to incomes in most countries since 2000. Housing is becoming more affordable, not more expensive. Risks fall accordingly;

7) Hong Kong is the key exception to this rule. There, home prices relative to income have risen by 78% since 2000. This is cause for concern;

8) Debt and leverage are important when it comes to assessing risk. Housing debt as a percentage of income is rising across Asia. Most of this is normal. Housing is a ‘superior good’, people spend proportionately more on it as incomes rise;

9) Asia’s housing debt as a percentage of income remains very low compared to the US, where it stands at 5.5% of GDP. Debt to GDP is about 3% in Singapore, Hong Kong and Taiwan. In China, housing debt is a very low 1.4% of GDP;

10) When interest rates go up, risks go up. As mortgage rates return to precrisis averages, monthly housing payments in most Asian countries will rise by 15%-25%. Some families will likely find themselves over-extended.

11) Housing payments are unlikely to rise by much in China, Malaysia, Thailand or India, as interest rates there did not fall by much during the global financial crisis;

12) Indonesia and the Philippines appear most vulnerable to higher interest rates;

The US is as vul-nerable to higher interest rates as Asia. This could delay the removal of QE3 far longer than most antici-pate

19


13) The US appears every bit as vulnerable to higher interest rates as Asia. This could delay the removal of QE far longer than most currently anticipate.

Finally, we note that to the extent Asia’s rising home prices follow from capital inflows, this is not likely to end when global interest rates go up. Quantitative easing in the G3 and low global rates are only part of Asia’s inflow story. The much larger, and longer-term driver of capital inflows into the region is the fact Asia now generate’s the lion’s share of the world’s incremental growth. Put simply, businesses want to be where the growth is. This means investment and capital inflows into Asia are likely to continue long after monetary policy in the G3 has returned to normal.

Property prices will likely continue northward as well.

Loose monetary policy in the G3 isn’t the main driver of capi-tal inflows into Asia. The biggest driver is the fact that Asia now generates the lion’s share of the world’s incremen-

Notes:

[1] Per capita GDP is used as the measure of income.

[2] The following interest rates are used to proxy mortgage rates.

China 5YR PBOC less 10% discountHong Kong since Jan 2007: 3m Hibor+1.75%

pre-Jan 2007: prime rate less 2.00%Korea Avg CB housing loan rateTaiwan Avg home loan rate, top 5 banksSingapore 12m Sibor + 1.25%Malaysia BLR - 2.00%Thailand MLR - 1.00%Indonesia BLR - 1.50%Philippines Avg MM rate all instr + 3.50%India 3m Mibor + 2.25%US Adj rate mortgage rateJapan Priv dwelling housing loan rate

Sources:

Except where noted, data for all charts and tables are from CEIC Data, Bloomberg and DBS Group Research (forecasts and transformations).

20


Appendix I: residential house price indices

75100125150175200225250275300325350375400425

00 02 04 06 08 10 12 14

USD terms

local ccy terms

China – residential property pricesMar00=100, nsa

50

75

100

125

150

175

200

225

250

00 02 04 06 08 10 12 14

USD terms

local ccy terms

Hong Kong – residential property pricesMar00=100, nsa

75

100

125

150

175

200

00 02 04 06 08 10 12 14

USD terms

local ccy terms

Taiwan – residential property pricesMar00=100, nsa

75

100

125

150

175

200

00 02 04 06 08 10 12 14

USD terms

local ccy terms

Korea – residential property pricesMar00=100, nsa

75

100

125

150

175

200

225

00 02 04 06 08 10 12 14

USD terms

local ccy terms

Singapore – residential property pricesMar00=100, nsa

75

100

125

150

175

200

225

00 02 04 06 08 10 12 14

USD terms

local ccy terms

Malaysia – residential property pricesMar00=100, nsa

21


75

100

125

150

175

00 02 04 06 08 10 12 14

USD terms

local ccy terms

Indonesia – residential property pricesMar00=100, nsa

75

100

125

150

175

200

00 02 04 06 08 10 12 14

USD terms

local ccy terms

Thailand – residential property pricesMar00=100, nsa

Appendix I: residential house price indices (con’t)

22

Economics–Markets–StrategyCurrencies

Philip Wee • (65) 6878 4033 • [email protected]

CU

RR

ENC

IES

FX: Looking past volatilityAsia: Market volatility extended into 2Q13; Fed tapering fears

displaced yen weakness as main worry

Fears of withdrawal of Fed stimulus overdone

Look for sentiment to improve, albeit cautiously, with global recovery prospects in 2H13

CNY: Volatility-free steady appreciation

HKD: No speculation on peg

TWD: Keeping stable between 29 and 30

KRW: Looking up on exports

SGD: Appreciation slows with growth/inflation

MYR: Pendulum

THB: Re-aligned to Asian peers

IDR: Targeting stability

PHP: Favoring more modest appreciation

INR: On negative watch

VND: Ready to depreciate again

USD: Upside exhausted

JPY: Excessively weak?

EUR: Underpinned by Germany

AUD: Oversold

NZD: Resisting lower AUD/NZD

DXYEURCHFCADGBPNZDAUDJPYCNYINRBRLRUBZARHKDVNDTHBIDRMYRSGD

1.5 1.1

-0.5

-2.8-3.5 -3.6

-8.8-9.6

1.6

-4.8 -5.0 -5.2

-16.1

-0.2-0.9 -1.2

-2.3 -2.3 -2.8 -2.8

-4.6-5.7

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2

4

DX

Y

EUR

CH

F

CA

D

GBP

NZD

AU

D

JPY

CN

Y

INR

BRL

RU

B

ZAR

HK

D

VN

D

THB

IDR

MY

R

SGD

TWD

PHP

KR

W

USD, EUR and CNY weathered volatility in the first half of the year

% change vs USD, 12 Jun 2013 vs 31 Dec 2012* USD is performance of DXY index

MAJOR CURRENCIES EMERGING ASIAN CURRENCIESB R I C S

23

CurrenciesEconomics–Markets–Strategy

Currency forecasts

12-Jun 3Q13 4Q13 1Q14 2Q14

EUR/usd 1.3336 1.31 1.32 1.34 1.35Previous 1.35 1.36 1.37 1.38

Consensus 1.28 1.26 1.26 1.26

usd/JPY 96.00 100 102 104 105Previous 100 102 104 105

Consensus 103 105 106 107

usd/CNY 6.1335 6.09 6.06 6.03 6.00Previous 6.11 6.07 6.05 6.00

Consensus 6.12 6.10 6.08 6.05

usd/HKD 7.7643 7.77 7.78 7.79 7.80Previous 7.79 7.80 7.80 7.79

Consensus 7.76 7.76 7.77 7.76

usd/KRW 1128 1100 1080 1060 1040Previous 1040 1030 1020 1017

Consensus 1108 1100 1086 1080

usd/TWD 29.875 29.6 29.4 29.2 28.9Previous 28.8 28.6 28.4 28.3

Consensus 29.9 29.6 29.4 29.0

usd/SGD 1.2557 1.24 1.23 1.21 1.19Previous 1.20 1.19 1.18 1.18

Consensus 1.25 1.25 1.24 1.22

usd/MYR 3.1300 3.02 2.99 2.96 2.94Previous 3.04 3.00 2.96 2.95

Consensus 3.05 3.02 3.00 3.04

usd/THB 30.950 29.9 29.8 29.7 29.6Previous 29.5 29.4 29.3 29.0

Consensus 29.8 29.5 29.4 30.2

usd/IDR 9855 9850 9800 9750 9700Previous 9550 9500 9450 9420

Consensus 9825 9850 9810 9815

usd/PHP 43.000 41.5 41.0 40.5 40.0Previous 39.7 39.3 39.0 38.8

Consensus 41.4 40.8 40.6 40.7

usd/INR 57.790 56.2 56.6 57.0 57.4Previous 53.5 53.0 52.5 52.3

Consensus 54.5 54.1 53.5 53.0

usd/VND 21000 21100 21200 21300 21400Previous 20750 20750 20750 20750

Consensus 21000 21000 21000 21000

AUD/usd 0.9480 0.98 1.00 1.02 1.04Previous 1.06 1.08 1.10 1.10

Consensus 0.97 0.97 0.96 0.96

NZD/usd 0.7986 0.80 0.82 0.84 0.86Previous 0.85 0.86 0.87 0.87

Consensus 0.81 0.80 0.80 0.82

DBS forecasts in red. Consensus are median forecasts collated by Bloomberg as at June 12, 2013

24


Global volatility and the weak yen and Fed

Global currency markets were volatile in the first half of 2013. Two broad themes underpinned the US dollar – a weak Japanese yen and fears that the US Federal Reserve may taper asset purchases. In turn, this ended the half-year recovery (in 2H12) of Asia ex Japan currencies from the Eurozone crisis. With most of their economies disappointing in 1Q13, markets in emerging Asia remained under pressure in 2Q13.

By late May, signs emerged that the yen/Fed themes may be running into headwinds themselves. Hence, it is too early to conclude that the volatility in the first half will extend into the rest of 2013.

Many things have changed in Japan to suggest that the yen is no longer as excessively strong as it was in November. On a relative basis, the Nikkei 225 index closed its gap with the Dow Jones Industrial Average. Real GDP growth was stronger than the US in 1Q13, at least in year-on-year terms. Current account deficits reversed into surpluses even whilst trade deficits persisted. Consensus turned more confident that Japan would achieve its 2% inflation target in 2014 by the time the Bank of Japan (BOJ) moved aggressively on quantitative easing measures in April.

Against this constructive backdrop, 10Y Japanese government bond (JGB) yields spiked in late May when USD/JPY rose above 100 to a high of almost 104. In turn, this triggered a more-than 20% correction in the Nikkei in May/June after it peaked at just below its multi-decade trendline resistance.

These price actions reminded us of comments made by PM Abe’s economic adviser Koichi Hamada in January regarding the yen’s level. Hamada considered USD/JPY around 95-100 as nothing to worry about. He reckoned that concerns would start to arise above 100, with levels above 110 considered as problematic. Coincidentally, according to Reuters Corporate Survey conducted in May, most Japanese corporates also viewed the same 95-100 range as their comfort zone for USD/JPY. Hence, USD/JPY may consolidate in a wide 95-105 range over next 12 months.

Despite USD/JPY’s fall below 100, there was no let up in the speculation that the Fed would taper asset purchases by end-2013 or early 2014. This was reflected by the rise in the 10Y treasury yield to 2.21% on June 10, its highest level since April 2012, from a low of 1.63% on May 2. There was confidence that, five years after the 2008 global financial crisis, the US economy had turned the corner and was ready to exit QE3. The reasons often cited were record high US equities and the recoveries in the US housing and jobs markets. In particular, the unemployment rate was expected to fall to the Fed’s 6.5% target in the second half of 2014.

3-Jan-114-Jan-115-Jan-116-Jan-117-Jan-11

10-Jan-1111-Jan-1112-Jan-1113-Jan-1114-Jan-1117-Jan-1118-Jan-1119-Jan-1120-Jan-1121-Jan-1124-Jan-1125-Jan-1126-Jan-1127-Jan-11

65

70

75

80

85

90

95

100

105

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Jul-12 Oct-12 Jan-13 Apr-13

JGB turned volatile when USD/JPY > 100

USD/JPY

10Y JGB(% pa, left)

4-Jan-895-Jan-896-Jan-899-Jan-89

10-Jan-8911-Jan-8912-Jan-8913-Jan-8917-Jan-8918-Jan-8919-Jan-8920-Jan-8923-Jan-8924-Jan-8925-Jan-8926-Jan-8927-Jan-8930-Jan-8931-Jan-89

5000

10000

15000

20000

25000

94 96 98 00 02 04 06 08 10 12 14

Nikkei 225 retreats from multi-decade resistance

25


In our view, there are more reasons for the Federal Reserve to sit tight than to taper asset purchases. Given the volatility in global bond markets in May/June, and its negative spillover into currency markets, the the FOMC meeting on June 18-19 will be important to watch for the Fed’s guidance and intentions on asset purchases. Fed Chairman Ben Bernanke is also scheduled to hold a press conference after the meeting.

The Fed has set two criteria to exit QE3 and move away from ultra-low US interest rates. First, the US unemployment rate should first fall below 6.5%. Second, inflation should rise above 2.0% with the pain threshold seen at 2.5%.

On the first criteria, the market has set a straight-line projection for the US jobless rate to fall to 6.5% in 2014. Unfortunately, things are never that simple. The ISM manufacturing PMI fell to 49.0 in May, its lowest level since June 2009. Similarly, the employment sub-indices for both the ISM manufacturing and services also fell steadily to near breakeven levels of 50.1 in the same month. These weaknesses, if they persist, have been known to moderate the pace, or even reverse, the fall in the jobless rate.

On the second criteria, the Fed highlighted that US inflation was falling “well below” its 2% target before it inserted a new line, “to increase or reduce the pace of its asset purchases” into its FOMC statement on May 1. Why the sudden interest in disinflation? The answer probably lies in the relationship between the US housing market and real long-term US bond yields.

According to the NAHB housing market index, the US property sector merely stabilized during QE1 and QE2. The housing recovery took off only after real long bond yields turned negative during Operation Twist. Bond yields fell swiftly because investors sought safety from the Eurozone crisis. Inflation took a longer time to follow yields lower because of the rise in commodity prices that accompanied the recovery from the 2008 crisis. Conversely, the NAHB index appeared to have lost some momentum in recent months when the same real long rates turned positive. Only this time, rising 10Y US bond yield and falling US inflation were headed in opposite directions of the Fed’s 2% inflation target.

Apart from jobs and inflation, the Fed will probably remain mindful that the White House and the Republicans are far from finding common ground on a medium-term plan for fiscal consolidation. The Congressional Budget Office (CBO) estimates that US lawmakers have until October or November to lift the federal debt ceiling. By then, the US Treasury Department would have exhausted extraordinary measures to keep paying government bills including bond payments. Failure here would risk undermining America’s credit standing. Perhaps that’s why Fed officials pushing for tapering asset purchases are focused on mortgage-backed securities and not treasuries.

Jan-98Feb-98Mar-98Apr-98

May-98Jun-98Jul-98

Aug-98Sep-98Oct-98Nov-98Dec-98Jan-99Feb-99Mar-99Apr-99

May-99Jun-99Jul-99

-4

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12

20

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90

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

ISM signals caution against US jobs optimism

US unemployment rate(% sa, right)

Employment sub-indices ISM manufacturingISM non-manufacturing

Fed's 6.5% jobless target

6-May-087-May-088-May-089-May-08

12-May-0813-May-0814-May-0815-May-0816-May-0819-May-0820-May-0821-May-0822-May-0823-May-0827-May-0828-May-0829-May-0830-May-08

2-Jun-083-Jun-08

-50

-40

-30

-20

-10

0

10

20

30

40

50

60

-2

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2

4

6

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10

2008 2009 2010 2011 2012 2013

US housing recovery and real LT interest rates

QE1 QE2 QE3

10Y UST(% pa)

US CPI(% YoY)

NAHB housing market index (right)

Op Twist

26


Negative spillover into emerging Asian currencies

The sell-off in emerging Asian currencies in May/June was different from the one in January-March in two regards. First, it was not due to a stronger US dollar. USD/JPY fell back into its 95-100 range and dragged the DXY index down. The sell-off in Asia ex Japan currencies was part of an unwinding of risk assets globally from fears that the Federal Reserve may wind down its stimulus. The hard hit currencies were those (AUD, KRW, INR and THB) that cut rates to address their disappointing economies. The currencies that had been appreciating for most of this year (INR, THB and NZD) gave up their gains and ended up weaker for the year. The depreciation in the fundamentally stronger THB and NZD were more of conscious choices by their governments to realign them with their weaker counterparts. The INR tumbled to a new life-time low on renewed fears that it may lose one of its investment grade debt rating due to India’s weak growth momentum and twin deficits. Conversely, the Philippines was upgraded to investment grade but this did not stop the PHP from becoming the worst performing currency in Southeast Asia during this period. Ironically, the IDR turned out to be one of the least volatile Asian currencies because of its steady depreciation. The sell-off in export-led Asian currencies (SGD, TWD and KRW) about the same as the January-March with SGD and TWD continue to track each other closely in weakness.

3-Dec-124-Dec-125-Dec-126-Dec-127-Dec-12

10-Dec-1211-Dec-1212-Dec-1213-Dec-1214-Dec-1217-Dec-1218-Dec-1219-Dec-1220-Dec-1221-Dec-1224-Dec-1225-Dec-1226-Dec-1227-Dec-12

-8

-6

-4

-2

0

2

4

Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13

VND

IDR

INR

Deficit-led Asian currencies

% YTD change vs USD3-Dec-124-Dec-125-Dec-126-Dec-127-Dec-12


-20

-15

-10

-5

0

5

10


EUR

NZD

AUD

JPY

Major & antipodean currencies

% YTD change vs USD

3-Dec-124-Dec-125-Dec-126-Dec-127-Dec-12


-8

-6

-4

-2

0

2

4

6

8


CNY

TWD

SGD

KRW

Export-led Asian currencies

% YTD change vs USD3-Dec-124-Dec-125-Dec-126-Dec-127-Dec-12


-8

-6

-4

-2

0

2

4

6

8


THB

MYR

IDR

PHP

Domestic-led Southeast Asian currencies

% YTD change vs USD

27


From market volatility in 1H13 to global recovery in 2H13

Sentiment is likely to improve in the second half of the year. Optimism is, however, likely to remain cautious after the market volatility in May/June.

The main event in 3Q13 is the G20 Leaders’ Summit in Moscow on September 5-6. Over the past twelve months, the G20 has moved from defusing tail risks in the Eurozone crisis in 2H12, to countering yen-led currency war worries in 1H13. Topping the agenda at this upcoming meeting will be the challenge of withdrawing US stimulus without hijacking the global recovery.

America will make its case that the global recovery cannot be led by the US alone. China and Germany, the largest surplus-led economies in their respective regions, will be encouraged to lead growth with more domestic demand. Japan will want to be heard that it is also contributing here via Abenomics.

Despite the volatility in global currency markets, China been guiding the yuan steadily stronger and stepping up efforts to promote the yuan as an international payments currency. China’s new leaders, President Xi Jinping and Premier Li Keqiang, would probably present their agenda to deepen and accelerate economic and financial reforms to move the Chinese economy more towards consumer spending and services.

German Chancellor Angela Merkel announced that a strong euro will be part of her party’s platform at the federal elections in September. She views the 1.30-1.40 range as a historical norm for the euro. Merkel elaborated that Germany has a duty to boost domestic demand to support the eurozone economy. Germany has returned to balanced budget with a solid current account surplus of more than 4% of GDP.

The above scorecard sees China, Germany and Japan leaning towards boosting domestic demand. US President Barack Obama has been actively pushing to forge more trade deals with Europe and Asian countries, which has become a priority in his second-term agenda to boost growth and create jobs in the US.

Put together, it does not look like America is in a hurry to return to a Strong USD policy. When this policy started in 1995, the US unemployment rate had already fallen below the Fed’s 6.5% target with inflation also above the 2% target. Back then, Japan had also entered into a full-blown banking and property crisis, and asked the G7 for help to stop the yen’s appreciation. Japan was the main player in the global rebalancing story back then. Today, it is China.

Here’s the bottomline. The surprise in the second half of the year could well be the return of a weaker US dollar on the back of more global cooperation and coordination to return to the world economy to a more balanced and sustainable growth path.

Jan-80Feb-80Mar-80Apr-80May-80Jun-80Jul-80

Aug-80Sep-80Oct-80Nov-80Dec-80Jan-81Feb-81Mar-81Apr-81May-81Jun-81Jul-81

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12

14

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Reagan ReaganTerm II

Is US ready to return to a Strong USD policy? Think again

Obama Term II

Obama Term I

US CPI inflation( % YoY)

US unemployment rate, % sa(When the jobs market was this bad)

Fed's 6.5% jobless target

Fed's 2% inflation target

Strong USDpolicy

Bigbudgetdeficits

Fiscalconsolid-

ation

Fiscalconsolid-

ation

Bigbudgetdeficits

Weak USDSep 85 to

Dec 87

28


US dollar

DXY upside exhausted by doubts over weak yen and Fed’s intentions on asset purchases

The strong US dollar in the first five months of this year had been mostly about a weak Japanese yen and worries that the Fed may start to exit QE3 sooner than later. Both these factors may fall short in 3Q13. The yen is likely to consolidate after the yen-Nikkei-JGB volatility in late May. Focus has potential to shift from the Fed towards the US budget impasse again. The US Treasury Department estimated that it has, until the September 2 Labor Day holidays, to exhaust its extraordinary measures to keep paying all of the government’s bills including bond payments. Failure by the White House and Republicans to reach a compromise would probably lead to stop-gap funding measures on October 1, the start of the new fiscal year, and a showdown on the federal debt limit in November. With inflation well below the Fed’s 2% target amidst weaker inflation expectations, it will be hard to see the Fed tapering bond purchases this year without risking America’s credit standing. Lest we forget, the Fed has, in its FOMC statement on May 1, also opened the door to increase asset purchases as well. Note that ISM manufacturing PMI fell below 50 to 49 in May, its lowest reading since June 2009.

Euro

EUR/USD has scope to return to its 1.30-1.40 historical norm

The euro was remarkably resilient in 2Q13 after the Cyprus crisis in late March. EUR/USD consolidated mostly between 1.28 and 1.32, in spite of a surprise rate cut by the European Central Bank (ECB) on May 2. While Eurozone continues to struggle with negative growth and high joblessness, sentiment has, nevertheless, improved from a year ago. Two factors signaled that the worst was probably over for the sovereign debt crisis. First, government bond yields of struggling EU nations fell back to pre-crisis lows. Second, Portugal successfully returned to the bond market for the first time since its bailout. Spain and Italy also attracted strong demand for their bond issues. More importantly, the friendlier market environment opened the door for the Eurozone to balance austerity with growth. Looking ahead, September will be an important month to watch. Germany will be urged at the G20 Summit to stimulate domestic demand and help Eurozone return to growth. German Chancellor Angela Merkel announced that a strong euro will be part of her CDU’s party campaign for the September federal election. FYI, Merkel said in February that a euro rate of 1.30-1.40 was in line with historical norm.


DXY 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 80.947 82.8 82.6 81.9 81.6Previous 80.4 80.0 79.6 79.2Consensus 84.4 85.6 85.9 85.8

Policy, % 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 0.25 0.25 0.25 0.25 0.25Previous 0.25 0.25 0.25 0.25Consensus 0.25 0.25 0.25 0.25

72

74

76

78

80

82

84

86

88

90

72

74

76

78

80

82

84

86

88

90

2010 2011 2012 2013 2014

DXY index – upside exhausted

72

74

76

78

80

82

84

86

88

90

72

74

76

78

80

82

84

86

88

90

2010 2011 2012 2013 2014

DXY index – upside exhausted


EUR /usd 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 1.3336 1.31 1.32 1.34 1.35Previous 1.35 1.36 1.37 1.38Consensus 1.28 1.26 1.26 1.26


1.15

1.20

1.25

1.30

1.35

1.40

1.45

1.50

1.55

1.15

1.20

1.25

1.30

1.35

1.40

1.45

1.50

1.55

2010 2011 2012 2013 2014

EUR/USD – historical norm is 1.30-1.40

29


Chinese yuan

CNY appreciation trend intact; USD/CNY on track to 6.00 by mid-2014

China consistently set the official central parity for USD/CNY to new record lows so far this year. As at June 7, the yuan was fixed 2.0% stronger from end-2012 levels. Interestingly, the appreciation was slower in the onshore CNY (1.6%) and the offshore CNH (1.4%) in Hong Kong. Why the differences? On the policy front, we believe that China is moving as fast as it could to make the yuan “basically convertible” by 2015. According to SWIFT, the yuan has emerged as the 13th most used currency for international payments in March. This was a dramatic climb from its 20th position only 15 months ago in January 2012. Markets, meanwhile, struggled to reconcile the strong yuan with slower growth in China, and a strong US dollar from a weak yen and Fed tapering fears in 1H13. Looking ahead, China is expected to further liberalize interest rates, advance the yuan’s internationalization by increasing capital account convertibility and move towards a more flexible and market-determined yuan exchange rate. There is expectation that the official USD/CNY trading band may be widened to ±2% from the present ±1% around the central parity as early as the US-China Strategic Economic Dialogue in July.

Japanese yen

From correcting excessive yen strength to worrying about excessive yen weakness

For the six months between mid-November and late May, Abenomics worked well as a “weak yen, strong equity” story. That is until the Japanese bond market turned volatile in late May and brought the Nikkei down 20%. What went wrong? Nothing really. People simply started to believe that Abenomics may succeed in reinvigorating the stagnant Japanese economy. By April 4, the day the Bank of Japan delivered aggressive QE, there was consensus that Japan would succeed in achieving its 2% inflation target in 2014. Lest we forget, the weak yen story that started last November was about beating deflation by correcting the yen’s excessive strength. The JPY-Nikkei-JGB volatility also affirmed that government’s less vocal worries about excessive yen weakness. Back in January, economic adviser Hamada said that 95-100 was “nothing to worry” about for the yen, and that the dollar’s rise to 110 or more would become a problem. Interestingly, Japanese corporates also favored the 95-100 range, according to a Reuters poll. Hence, USD/JPY may start to consolidate as it lets fundamentals play catch up to the euphoria discounted in the Japanese markets.


usd/ JPY 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 96.00 100 102 104 105Previous – 100 102 104 105Consensus – 103 105 106 107

Policy, % 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 0.10 0.10 0.10 0.10 0.10Previous – 0.10 0.10 0.10 0.10Consensus – 0.10 0.10 0.10 0.10

75

80

85

90

95

100

105

110

75

80

85

90

95

100

105

110

2009 2010 2011 2012 2013 2014

USD/JPY – six month rally gives way to consolidation


usd/ CNY 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 6.1335 6.09 6.06 6.03 6.00Previous 6.11 6.07 6.05 6.00Consensus 6.12 6.10 6.08 6.05


5.80

6.00

6.20

6.40

6.60

6.80

7.00

7.20

7.40

5.80

6.00

6.20

6.40

6.60

6.80

7.00

7.20

7.40

2008 2009 2010 2011 2012 2013 2014

USD/CNY – volatile-free yuan appreciation

30


Hong Kong dollar

Lessons from 1H13 and 4Q12 – weak USD, not just strong CNY, needed to fuel HKD peg speculation

Despite the steady appreciation of the Chinese yuan, and more talk of increasing capital account convertibility in China, there was little or no mention that Hong Kong may abandon its HKD peg to the US dollar in 2Q13. This was a sharp contrast to 4Q12 when the Hong Kong Monetary Authority (HKMA) intervened many times to defend the HKD peg against speculation that it may abandon the greenback in favor of the yuan. The reason was simple. The greenback was weak in 4Q12 from the start of the Fed’s QE3 last September. That changed in mid-January when the weak Japanese yen and Fed tapering fears underpinned the US dollar against other Asian currencies including the HK dollar. It also did not help that the HKMA was warning of overheating risks in the HK economy, citing the sharp narrowing in the current account surplus to 1.3% of GDP in 2012 from its peak of 15% in 2008, amidst an increase in total household debt to a record 61% of GDP. While the stronger yuan was the primary reason for the recovery in yuan deposits in the territory, the weaker HK dollar did, nonetheless, preside over their rise to new record highs starting from February.

Taiwan dollar

Nearing the top of its 29-30 range, USD/TWD faces more downside than upside risks

USD/TWD has been trapped mostly between 29 and 30 since early 2012. The move from the floor to the ceiling of this range in 1H13 was predicated on external and domestic factors. Globally, currency markets were volatile from a weak yen and Fed tapering fears underpinning the US dollar. Domestically, fundamentals failed to live up to optimism set at the start of the year. On May 24, the Taiwan government downgraded its 2013 official growth and inflation forecasts to 2.40% and 1.23% respectively. This was a sharp contrast from February 22, when the official estimates for growth was upgraded to 3.59% from 3.53%, and inflation to 1.37% from 1.31%. Sentiment was dampened after real GDP growth retreated to 1.8% YoY in 1Q13 after a better-than-expected 3.9% in 4Q12. Assuming no more downside surprises in the outlook, Taiwan is still on track for growth to re-accelerate in 2H13 into 2014. This “optimism” is reflected by our expectation for USD/TWD to fall modestly below 29 by mid-2014. To move the target towards the 2011 low of 28.50, exports must rise to record highs alongside foreign reserves.


usd/ HKD 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 7.7643 7.77 7.78 7.79 7.80Previous 7.79 7.80 7.80 7.79Consensus 7.76 7.76 7.77 7.76


7.74

7.75

7.76

7.77

7.78

7.79

7.80

7.81

7.82

7.74

7.75

7.76

7.77

7.78

7.79

7.80

7.81

7.82

2010 2011 2012 2013 2014

USD/HKD – off the lows of convertibility band


usd/ TWD 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 29.875 29.6 29.4 29.2 28.9Previous 28.8 28.6 28.4 28.3Consensus 29.9 29.6 29.4 29.0


28.0

28.5

29.0

29.5

30.0

30.5

31.0

28.0

28.5

29.0

29.5

30.0

30.5

31.0

2011 2012 2013 2014

USD/TWD – keeping to a tight 29-30 range

31


Singapore dollar

SGD to maintain its appreciation vs USD in 2H13 albeit in a weaker path

With real GDP growth and CPI inflation coming in lower-than-expected in Singapore, USD/SGD has moved into the upper half of its descending price channel. We now expect the SGD’s appreciation to track this weaker path for the rest of the year. This is in line with the downgrades in our growth and inflation outlook for 2013. Real GDP growth is now expected to be 2.5% this year instead of 3.2%, while inflation is likely to average 2.8% vs 4.0% previously. CPI inflation fell dramatically to 1.5% YoY in April, thanks to macroprudential measures to curb credit for house and car purchases. Not only was April the lowest inflation since February 2010, it was also well below the official 3-4% inflation target. Despite this, the central bank (MAS) is not letting its guard down on core inflation. Labor conditions are expected to remain tight from restructuring efforts to reduce the country’s dependence on cheap foreign labor and move its economy towards productivity-driven growth. Hence, the MAS will probably maintain the status quo of a modest and gradual appreciation exchange rate policy at the next policy review in October.

Korean won

USD/KRW to revisit its 2011 low when the external recovery improves next year

The won was the only export-led Asian currency that was close to fully recouping its losses incurred during the Eurozone crisis. The attempt was hijacked in mid-January when the weak Japanese yen and Fed tapering talks underpinned the US dollar into May. Korea also sought to partially counter Japan’s aggressive monetary policies with a 25 bps rate cut to 2.75% on May 9. On a positive note, these lower rates, coupled with the KRW5.3 trillion supplementary budget, should help the Korean economy to perform better in 2H13. Despite its volatility, the won is well supported by its improving international liquidity position. This was best reflected by record high foreign reserves (April: $329 bn) vs falling short-term external debt (1Q13: $122 bn). The current account surplus exceeded 4% of GDP in 2012 for the first time since 2009. The trade surplus totaled USD14.1 bn in the first five months in 2013, with the full-year surplus likely to exceed the USD28.3bn posted in 2012. Export growth turned positive year-on-year in 1Q13 after three straight quarters of declines. This time next year, the won will probably be close to its 2011 high again.


usd/ KRW 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 1127.8 1100 1080 1060 1040Previous 1040 1030 1020 1017Consensus 1108 1100 1086 1080


900

1000

1100

1200

1300

900

1000

1100

1200

1300

2010 2011 2012 2013 2014

USD/KRW – trending lower in upper channel


usd/ SGD 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 1.2557 1.24 1.23 1.21 1.19Previous 1.20 1.19 1.18 1.18Consensus 1.25 1.25 1.24 1.22


1.15

1.20

1.25

1.30

1.35

1.15

1.20

1.25

1.30

1.35

2011 2012 2013 2014

USD/SGD – shifting downtrend to upper channel

32


Malaysian ringgit

USD/MYR continues be volatile in a lower but wide 2.95-3.10 range

The ringgit staged a brief relief rally after the ruling Barisan Nasional coalition secured a simple majority in parliament at the closely-fought general elections on May 5. USD/MYR fell to a low of 2.9745 on May 9 before it spiked to almost 3.10 on June 4 on external and domestic factors. The ringgit was pressured alongside other Asian currencies after the Japanese yen depreciated past 100 on May 9. Less than a week later, on May 15, Malaysia’s economy disappointed with growth slipping to 4.1% YoY growth in 1Q13 from a 2.5-year high of 6.5% in 4Q12. It was also the first time since 2Q11 that real GDP growth slipped below 5%. The sub-par performance was blamed on exports which contracted for the third straight quarter in 1Q13. Conversely, imports picked up to 5.5% YoY in 1Q13 from 1.2% in the previous quarter. This coupled a rise in inflation to 1.5% YoY from 1.3% during the same underscored the dependence of the economy on domestic demand. The trade surplus narrowed to MYR11.2 bn in the March quarter after 34 quarters of surpluses in excess of MYR20 bn. The above factors signal that USD/MYR will be patient in revisiting its 2011 low below 2.95.

Thai baht

Policy resistance against appreciation to keep the baht near the 30 level

The baht was one the most volatile Asia ex Japan (AXJ) currencies in the first half of this year. By April 19, the baht appreciated almost 7% year-to-date to its strongest level since July 1997. Over the next seven weeks, its fortunes were reversed. By early June, the currency returned more than 90% of the gains accummulated in the first 3.5 months. These large swings were in line with the fluctuations in its economy. Real GDP growth surged to a record high of 19.4% YoY in 4Q12, only to slip to 5.4% in 1Q13. The Bank of Thailand responded, on May 29, with a rate cut of 25 bps to 2.50%. Many believed that the cut was also aimed at discouraging baht appreciation. This should not come as a surprise. As at June 3, the baht and the Chinese yuan were the only two AXJ currencies that posted gains in 2013. PM Yingluk Shinawatra and her government have urged the central bank to impose more measures to keep the baht stable and competitive for exporters. Like GDP, export growth slowed to 4.5% YoY in 1Q13 from 18.2% in the previous quarter. The finance ministry reckoned that baht strength beyond 30 would be hard for the Thai economy.


usd/ MYR 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 3.1300 3.02 2.99 2.96 2.94Previous 3.04 3.00 2.96 2.95Consensus 3.05 3.02 3.00 3.04


2.85

2.90

2.95

3.00

3.05

3.10

3.15

3.20

3.25

2.85

2.90

2.95

3.00

3.05

3.10

3.15

3.20

3.25

2011 2012 2013 2014

USD/MYR – a pendulum around mid-channel


usd/ THB 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 30.950 29.9 29.8 29.7 29.6Previous 29.5 29.4 29.3 29.0Consensus 29.8 29.5 29.4 30.2


28

29

30

31

32

33

28

29

30

31

32

33

2010 2011 2012 2013 2014

USD/THB – correcting excessively strong baht

33


Philippine peso

The peso is likely to consolidate after its sharp correction in 1H13

Philippines’ favorable fundamentals were reflected in its stock market and not its exchange rate in 1H13. The benchmark Phisix stock index hit an all-time high in mid-May on the back of two investment grade debt ratings awarded by Fitch on March 27 and Standard & Poor’s on May 2. The Philippines overtook China as the fastest growing Asian country in the first quarter. Real GDP growth was 7.8% YoY in 1Q13 vs 7.7% in China. As for the peso exchange rate, it was volatile alongside its Asian counterparts from the weak yen and Fed tapering worries. The peso’s high achieved in mid-January coincided with the peak in foreign reserves that month. Export growth turned negative in 1Q13 after expanding for four straight quarters. Growth in overseas foreign worker (OFW) remittances in April was also the slowest since 2009. Quite clearly, domestic demand has been the main contributor to growth, especially from robust gross capital formation and higher government spending. With investments likely to translate into more imports, there will be an incentive to keep the peso’s appreciation modest until external demand improves again.

Indonesian rupiah

All eyes on fuel price hikes to stabilize USD/IDR below the psychological 10000 level

At the time of writing, the government is believed to be moving closer towards increasing subsidized fuel prices by 45%. This is likely to take place after the government completes its 2013 budget revisions by June 17. This decision will be important to prevent USD/IDR from rising above 10000, a psychological level often associated with crisis in Indonesia. That is probably the last thing the government would want heading into next year’s general elections. The fuel price hikes will help to limit the budget deficit to 2.5% of GDP in 2013 from the initial target of 1.65%. More importantly, they will help rein in the wider oil and gas trade deficits blamed for the persistent current account deficits keeping the rupiah on a depreciation path. As for higher fuel prices potentially lifting inflation to 7-8%, former finance minister Agus Martowardojo has left the door open for higher rates in his capacity as the new Bank Indonesia governor. The appointment of former investment board (BKPM) head, Muhamad Chatib Basri, as the new finance minister signaled commitment to improve the country’s savings-investment gap to create jobs and support growth.


usd/ IDR 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 9855 9850 9800 9750 9700Previous – 9550 9500 9450 9420Consensus – 9825 9850 9810 9815

Policy, % 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 5.75 5.75 5.75 6.00 6.25Previous – 5.75 5.75 5.75 5.75Consensus – 5.88 6.00 6.00 6.13

8000

8500

9000

9500

10000

8000

8500

9000

9500

10000

2011 2012 2013 2014

USD/IDR – seeking stability below 10000


usd/ PHP 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 43.000 41.5 41.0 40.5 40.0Previous 39.7 39.3 39.0 38.8Consensus 41.4 40.8 40.6 40.7


38

40

42

44

46

48

50

38

40

42

44

46

48

50

2009 2010 2011 2012 2013 2014

USD/PHP – resetting peso appreciation from mid-point

34


Indian rupee

INR is on negative watch again on India’s growth struggle with its multiple deficits

The rupee was the hardest hit amongst Asia ex Japan (AXJ) currencies from a weak yen and Fed tapering worries in 2Q13. This brought the rupee close to its lifetime low of 57.325 seen in June 2012. The sell-off exposed India’s vulnerability to potentially “tighter” US monetary policy. Owing to its multiple trade, current account, and fiscal deficits, India has increased its reliance on foreign investments, both portfolio and direct, to keep its balance of payments stable and support economic growth. Unfortunately, the deficits are preventing India from returning to the high growth rates that investors had grown used to before the global crisis. Real GDP growth continued to languish below 5% for two straight quarters into March. Without an improvement in external demand, rate cuts have only managed to offset the government spending cuts needed to rein in the fiscal deficit and safeguard the country’s investment grade debt ratings. Against these difficult circumstances, Standard & Poor’s warned, on May 17, of a 1-in-3 chance that India may lose its coveted investment-grade debt rating in the next 12 months.

Vietnam dong

USD/VND to stay close to the ceiling of its trading band established since 2011

The factors that underpinned the dong in 2012 have started to weaken. The economy started the year on a weak note with real GDP growth slowing to 4.89% YoY in 1Q13, below its official 5.5% target for 2013. Vietnam grew only 5.03% in 2012, its worst in 13 years. Despite this, the Ministry of Planning and Investment intends to propose a higher 7% growth target for 2014 at the National Assembly in November. To reaccelerate growth, the State Bank of Vietnam (SBV) has been encouraging banks to boost lending to support business activities. Between March 2012 and May 2013, the refi rate was cut seven times to 7% from 15%, thanks to low inflation. Except that this has encouraged companies to boost imports for production. With imports hitting record highs, trade surpluses have reversed into deficits since February. The USD1.2 bn deficit in May was the widest since September 2011. While it prefers a stable dong this year, SBV did not discount the possibility of a 2% devaluation. If so, USD/VND could end up higher at 21,245 by end-2013.


usd/ INR 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 57.790 56.2 56.6 57.0 57.4Previous 53.5 53.0 52.5 52.3Consensus 54.5 54.1 53.5 53.0


40

42

44

46

48

50

52

54

56

58

60

62

40

42

44

46

48

50

52

54

56

58

60

62

2009 2010 2011 2012 2013 2014

USD/INR – weak rupee profile in upper channel


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USD/VND – depreciation risks emerge

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New Zealand dollar

NZD/USD to bounce after it hits the floor of its ascending price channel

The Reserve Bank of New Zealand (RBNZ) surprised markets on May 8 when it admitted to intervention to contain its strong currency. This came one day after Australia surprised with a rate cut. It was also around this period that AUD/NZD fell to 1.20 for the first time since June 2009. Over the past year, the cross rate had been depreciating because of NZ’s relatively better fundamentals over its neighbor. Unlike Australia, NZ was looking to hike rates to curb its hot housing market and on track to return to a budget surplus by FY2014/15. Understandably, NZ policymakers were forced to look beyond monetary and fiscal policies, leaving them little choice but to support RBNZ’s intervention efforts. To avoid rate hikes that could bolster the NZD, the finance ministry and the RBNZ agreed to macroprudential measures to cool the housing sector. In anchoring AUD/NZD around 1.20, the NZD was not spared from the AUD’s woes. NZD/USD subsequently fell towards the floor of its ascending price channel. Assuming AUD/USD is oversold and due for a bounce, we reckon that NZD/USD will also start to rise from its low, but at a same/slower pace than AUD/USD.

Australian dollar

AUD/USD should find support around 0.94-0.97 unless the economic outlook falters

The Australian dollar was the worst performing currency in 2Q13. The exchange rate depreciated 8.9% from end-March to June 7. Most of the sell-off occurred in May (7.7%), during which AUD/USD also fell below its 1.0150-1.0600 range established since mid-2012. On the external front, the pressure came from a stronger US dollar due to a weak yen and Fed tapering talks. On the domestic front, the central bank surprised with a rate cut. The government delayed its plan to return to a balanced budget due to a sharp revenue shortfall which it blamed on weak commodity prices and a strong exchange rate. Despite the bearish sentiment, the Oz may be oversold. Speculative net short AUD positions hit a new record for the week ending June 4, which exceeded the previous record set in June 2012. Back then, the Oz was also pressured by a firm US dollar and weak commodities from the Eurozone crisis. Since 4Q11, AUD/USD has, on three occasions, rebounded to 1.06-1.08 after it bottomed at 0.94-0.97. Further falls below 0.90 would imply a dramatically weaker outlook for Asia in 2H13, which is contrary to our view.


AUD /usd 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 0.9480 0.98 1.00 1.02 1.04Previous 1.06 1.08 1.10 1.10Consensus 0.97 0.97 0.96 0.96


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AUD/USD – oversold at bottom of range


NZD /usd 12-Jun 3Q13 4Q13 1Q14 2Q14Revised 0.7986 0.80 0.82 0.84 0.86Previous 0.85 0.86 0.87 0.87Consensus 0.81 0.80 0.80 0.82


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NZD/USD – tracking AUD, but more slowly up

36

Economics–Markets–StrategyYield

Jens Lauschke • (65) 6682 8760 • [email protected]

YIE

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Yield: Transitioning to higher interest rates

• US: The US bond market is too complacent about rate hike risk. The level and steepness of the Treasury yield curve are still consistent with a deflationary environment, not recovery. USD interest rates have only one way to go

• SG: The flattening bias of the past two years appears to be giving way to a steepening bias. The SGD yield curve will continue to steepen in 2H13. The bulk of the curve steepening pressure will continue to come from higher yields around the 5Y sector, but even 2Y yields will move higher

• HK: The benchmark 2Y/10Y EFN yield curve, at around 130bps, is now about three times as steep as is was in 2H12, but the steepening is far from over

• KR: With the global interest rate environment changing, the next move from the Bank of Korea is likely to be a rate hike, not another cut. This suggests some steepening pressure even if the Korean economy is very weak and steepening potential ultimately limited

• TW: In addition to stronger domestic demand and faster credit growth, movements in the USD curve have the potential to lead to significant steepening pressure in Taiwan

• TH: With the current account position moving toward deficit, procyclical monetary policy should not turn more procyclical. The underlying case for higher interest rates is getting stronger. This will become clearer in the coming months when strong domestic demand continues to take a toll on the current account, weakening the Baht’s fundamentals. With these dynamics, the yield curve should steepen

• MY: Rate hike risk is slowly increasing, because domestic demand is fairly strong relative to external demand and the US economy continues to improve. Tighter monetary policy is becoming more likely despite the fact that the annual CPI inflation rate is low (1.7% in April) and monetary aggregates are expanding in line with their recent underlying trends

• ID: The rupiah continues to weaken and the annual headline CPI inflation rate is no longer comfortably within the central bank’s 3.5-5.5% target range. It’s time for Bank Indonesia to hike rates

• PH: Market rates remain disconnected from policy rates as a liquidity overhang is weakening the transmission of monetary policy to market interest rates. While ample liquidity in the banking system will continue to put downward pressure on rates, some curve steepening pressure is likely

• IN: Yields on government bonds can only fall with cuts in the repo rate for now, but scope for cuts in the repo rate is limited. In fact, recent weakness in the rupee makes the rate cuts in 1H13 look premature

• CH: With further interest rate liberalization on the agenda, lower economic growth does not mean lower interest rates. For the government bond market that means that there is no room for a sustained rally

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YieldEconomics–Markets–Strategy

Changing dynamics

The Chinese yuan has been making fresh record lows against the U.S. dollar in 2Q13 and another period of real effective exchange rate appreciation appears to be un-derway. That is good news for Asia, as it mitigates the risk of a sudden large reversal of capital flows.

As we first outlined on July 16, 2012 in “Asia: Volatile capital flows cloud bond market outlook,” the outlook for capital flows has become more uncertain. The push and pull factors that in recent years have sent large amounts of foreign capital into Asia are weakening. In many cases, cyclical pull factors look exhausted and there are more and more signs of changes in push factors. The US economy, for example, has regained its resilience and this is fuelling the fear that the turn in the global interest rate cycle is nearing. Europe has not reached that point of resilience yet, but recovery is expected to take hold.

With the large disparity in private sector growth dynamics between Asia and the advanced market economies in the past years, the region has been a prime target for capital in search for yield. Strong capital flows provided the liquidity for countercyclical monetary policy in the advanced market economies to translate into procyclical monetary policy in emerging market economies. The combination of ample liquidity and easy monetary policy resulted in strong investment and credit booms which boosted growth and returns, attracting and validating investment flows into the region.

These dynamics have been strong, as the desire of Asian emerging market economies to tightly manage their exchange rates (to preserve export-competitiveness) has generally limited their ability to conduct independent monetary policy. While the degree of active exchange rate management varies, most inhabit the middle ground of exchange rate regimes, participating in the FX market to smooth out excess volatility. In essence, they operate monetary policy frameworks that can be characterized as partial inflation targeting; they target both low inflation to safeguard sustainable growth and the exchange rate to safeguard external competitiveness.

The desire to manage the exchange rate is understandable. Providing for a stable currency is arguably the basic responsibility of any central bank. However, heavy exchange rate management also means that exchange rates can be misaligned with economic fundamentals and that risks increasing the size and volatility of capital flows for open economies. Emerging market economies tend to have financial sectors that are small and less developed but open to foreign investors. Managing large and volatile capital flows can be challenging and lead to more not less volatility.

Push and pull

Procyclical monetary policy is good news for investors in upswings but bad news in downturns. Therefore, it is no coincidence that investors are becoming more concerned about the outlook for emerging markets at a time when fear of a turn in the global interest rate cycle is intensifying and spreading. It merely reflects that push and pull factors behind portfolio flows into emerging markets have changed, and that is natural. What cannot go on forever will stop.

On the push factor side, the most important change is the strengthening in U.S. private sector activity, which is strong enough to allow the U.S. government to shift focus from supporting aggregate demand (through expansionary fiscal policy) to putting public finances on a sustainable path (through fiscal consolidation). U.S. private sector activity is firming and returning as the driver of domestic aggregate demand growth. Private domestic consumption, business investment and residential

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investment are all improving, allowing the US economy to expand despite fiscal contraction. If the private sector continues to strengthen and private sector demand for funds normalizes, the Fed will soon put a higher price tag on money. (see “U.S. Treasuries: Expensive”, April 1, 2013).

On the pull factor side, low world interest rates and ample liquidity have resulted in a strong expansion of private domestic demand in Asia. But, as is naturally the case, this was accompanied by a sharp increase in private sector debt and in many cases real effective exchange rate appreciation (a measure of overall cost-competitiveness relative to trading partners). As there is a limit to the extent to which private sector debt can increase without significantly increasing the risk to financial stability, these trends will not continue as they are increasingly likely to meet with counter measures from policymakers. This is likely, even if USD interest rates remain low for longer than expected.

Plainly, with the external demand environment weak, in the extreme, there are two mutually exclusive scenarios for emerging market economies:

1) domestic monetary policy stays highly accommodative and domestic demand growth remains strong amid ongoing credit and investment booms, weakening the current account through imports and making the economy and currency more vulnerable to swings in risk appetite and capital flows

2) domestic monetary policy is tightened and domestic demand growth slows amid slower credit and investment growth, so that current account dynamics don’t deteriorate and the economy and currency do not become more vulnerable to swings in risk appetite and capital flows

The actual scenario does not have to be one of these two extremes. In fact, it will fall somewhere in between, and it will include macroprudential tightening. But whatever the scenario, it is clear that in most cases it cannot be one of easy policy, strong domestic demand and strong external balances any more. Something has gotta give.

We think that as many Asian emerging market economies tightly manage their exchange rates, the combination of a more worrisome outlook for capital flows and weak external demand will oblige them to slow the growth in domestic private demand and pay more attention to cost competitiveness relative to their trading partners. We believe many are getting ready to migrate to a tighter monetary policy regime. The pace and degree of changes in the policy stance will vary across the region, depending on domestic economic conditions and the state of external balances. It will also be a function of how fast and in what way the Fed alters its monetary policy stance.

Whether because of tighter monetary policy or macroprudential measures, there will be a slowdown in capital accumulation in emerging markets and because of this growth rates will be lower. As a result, growth differentials with advanced market economies will become less favorable and GDP growth could become more volatile, especially once interest rates in the advanced market economies rise. That this shift is already taking place is most visible in China, with policymakers rebalancing the economy. In fact, China is just transitioning to a period in which investment plays a smaller role in driving growth.

What does all this mean for Asian rates markets? It means that investors have seen the lowest cost of capital and the most favrourable funding environment in both advanced and emerging market economies. As policy focus shifts from growth to stability in Asia, central banks will focus on containing domestic demand, inflationary pressures and currency volatility. That is not good news for bond markets. Monetary policy will tighten. Interest rate risk is increasing, as central banks will transition to higher interest rates. This is not appropriately reflected in most yield curves yet, but markets are starting to recognize what lies ahead and expectations are being adjusted. The end of easy money is nearing.

39


US: The US bond market is too complacent about rate hike risk

While high frequency indicators have been mixed of late, underlying growth in private aggregate demand appears to be strengthening and becoming increasingly robust. This is allowing the US government to undertake strong fiscal consolidation this year. Government revenues have already strengthened significantly in the first half of the current fiscal year and if they remain strong, would allow the full year deficit to be much lower than last year. The congressional budget office is projecting a deficit of USD 642 billion vs USD 1087 billion in 2012. The USD 445 billion shrinkage reflects a USD 363bn increase in revenues and a USD 82 billion decrease in outlays.

The spending cuts are still to come and the coming months will show whether private sector activity is robust enough to withstand the additional large fiscal adjustment. If growth holds up and government revenue continues to strengthen, then the conclusion would be no other than that the recovery in the US is well established. If private aggregate demand has regained its resilience, giving rise to sustained demand for funds, the Fed will gradually move towards exit, first by adding less stimulus, then by reducing liquidity and finally by hiking interest rates. Low interest rates increasingly have the potential to translate into more bank lending and there is the prospect of sustained positive feedback between private sector activity and credit. Moreover, if crisis-related financial stability risks and vulnerabilities have been mitigated, it is now time to pay more attention to potential and emerging financial stability threats. There are already concerns that the Fed is pushing portfolio rebalancing too far and causing excessive risk taking and a mispricing of credit risk in some markets. The sooner this happens, the better, as the longer interest rates stay low, the more sensitive markets will be to changes in interest rates when interest rates finally start to rise, complicating exit. We think the Fed could hike rates as early as 2015.

The level and steepness of the Treasury yield curve are still consistent with a deflationary environment (characterized by a low level of private sector activity and no net demand for funds), not recovery. That is changing. As private sector activity is normalizing, so too will interest rates. This will be priced into the yield curve progressively over the coming months, paced by the improvement in the unemployment rate towards the Fed’s 6.5% objective. By linking policy to economic targets in December last year, the Fed has already reestablished private sector expectations of the federal funds rate to fulfill their important automatic stabilizer function for the economy. As a lower unemployment rate materializes, the Fed will phase out its intervention and the market will gradually price in interest rate risk for 2015 and 2016, steepening the yield curve.

We expect yields on US Treasuries to rise. Yields in the 2Y sector are likely to end 2H13 near 0.8% and yields in the 10Y sector are likely to end 2H13 near 3%

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The level and steepness of the Treasury yield curve are still consistent with a deflationary environment, not recovery

40


Singapore: More steepening pressure ahead

While the USD and SGD yield curves remain firmly anchored near zero in the 3-6M sector, the flattening bias of the past two years appears to be giving way to a steepening bias. This year, it still is all about the slope of the yield curves and not the short-rate levels at which they are anchored. Even if US economic activity is strong enough to reduce excess capacity and the unemployment rate gradually falls to 6.5%, the earliest short-term rates could rise still looks like 2015.

The USD and SGD yield curves will continue to steepen in 2H13 when market participants continue to reassess Fed interest rate risk amid speculation on adjustments to the Fed’s quantitative easing programs. The bulk of the curve steepening pressure will come from higher yields around the 5Y sector, but even 2Y yields will likely rise somewhat. The 2Y/5Y curve spread in U.S. Treasuries could easily double from 75bps (as of 30 May) to 150bps by year end, which would add about 75bps to the 2Y/10Y benchmark curve and 10Y yields. A steepening of that degree would merely be normalization to levels more consistent with the current stage in the interest rate cycle.

When short-term rates are low, the 2Y/5Y curve tends to be steep. In fact, it tends to be steeper than the 5Y/10Y curve. This has not been the case since July 2011 because of the Fed’s rate guidance and Treasury purchases. In the absence of a major shock, it is only natural for the yield curve to steepen when Fed intervention is scaled back. This process has started and is likely to continue.

While high frequency indicators have been weak in 2Q13, the US economy has regained it resilience and is strong enough to withstand strong fiscal consolidation this year. Despite the weak data, the USD yield curve is steepening as the Fed is adjusting its forward guidance. As Fed Vice Chair Janet Yellen recently put it in a speech on communication in monetary policy: “The effects of monetary policy depend critically on the public getting the message about what policy will do months or years in the future. [...] What happens to the federal funds rate today or over the six weeks until the next FOMC meeting is relatively unimportant. What is important is the public’s expectation of how the FOMC will use the federal funds rate to influence economic conditions over the next few years.”

By adjusting forward guidance and asset purchases, the Fed is effectively altering the public’s perception of Fed rate hike risk over the next few years. It is preparing the market for rate hikes around 2015, in line with its forecast for the unemployment rate to fall below 6.5%. With these dynamics, the yield curve will continue to steepen.

We expect yields on benchmark Singapore government securities to rise. Yields in the 2Y sector are likely to end 2H13 near 0.4% and in the 10Y sector near 2.25%

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Chart 4: SGS 2/10 Spread vs UST 2/10 Spread

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Chart 3: 2Y/5Y& 5Y/10Y SGS Curve Segments

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The flattening bias of the past two years appears to be giving way to a steepening bias

41


Hong Kong: Steepening

With USD/HKD interbank interest rate differentials stable, recent increases in USD rates lifted fair value measures for HKD rates and both HKD swap rates and EFN yields have tracked these movements closely. As a result, the benchmark 2Y/10Y EFN yield curve, at around 130bps, is now about three times as steep as it was in 2H12.

While both the 2Y/5Y segment and the 5Y/10Y segment contributed to the move in the 2Y/10Y curve spread, like in the case of the USD yield curve, the major steepening move was in 2Y/5Y segment.

As we discussed on the preceding pages, the steepening is far from over. The movements in longer-term yields in the coming months and quarters will not be straight lines, but they will be along trajectories that are upward sloping. Short-term USD interest rates are still expected to remain low for some time, but there are more and more factors that suggest the risk of them rising soon is increasing.

However, despite improving economic conditions, rates around the 2Y sector do not price in any significant interest rate risk yet. This is most easily seen from the low implied yields on the Dec14 and Dec15 fed fund futures, which currently stand around 0.35% and 0.9%. Note that the 2Y sector at the end of the year will have to reflect rate expectations for 2014 and 2015. Some rate hike risk for 2015 will have to be priced in, if the labor market continues to improve.

The preceding pages also discuss that the USD 2Y/5Y curve is still flatter than the USD 5Y/10Y curve, which is unusual for the current stage in the economic cycle and reflects compressed liquidity and term premia. It should be steeper, as for example during the period from 2001 to 2005.

The market will likely price the federal funds rate to be lifted at a pace of 25bps per FOMC meeting and to a level above the 2% inflation target. As the FOMC meets eight times a year, it would take about a year to lift short-term rates above 2%. Market expectations will likely gravitate towards a terminal rate of around 2.5%, right between the 10Y average (1.8%) and 20Y average (3.2%). This would put the 2Y Treasury yield between 1.5% and 2% and the 10Y yield between 4% and 4.5%. These levels wont be reached this year, but we think that 10Y US Treasuries could easily end the year around 3%, driven by a normalization of the 2Y/5Y curve and some rise in the 2Y yield. The remaining rise in yields will come only when the 2Y sector prices near-term increases in the Federal Funds rate, which is not a 2013 story.

We expect yields on Hong Kong’s benchmark Exchange Fund Notes to rise. Yields in the 2Y sector are likely to end 2H13 near 0.9% and yields in the 10Y sector near 2.6%

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Chart 6: 2/10 EFN Curve vs 2/10 Swap Curve

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Chart 5: Hibor 3M vs Libor 3M

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The steepening in the HKD curves is far from over

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Korea: Weak economy limits steepening potential

Korea reported stronger-than-expected real GDP growth of 0.9% QoQ sa for 1Q13. That was the fastest quarterly expansion pace in two years and kept year-on-year growth at 1.5%. Private consumption contracted, but investment, govern-ment spending and net exports contributed to growth. Despite the better growth number, the Bank of Korea (BOK) cut the 7-day repo rate to 2.5% from 2.75% on May 9. The rate cut anchored the swap curve lower, but this is a one-off adjust-ment. The next move from the BOK is likely to be a rate hike, not another rate cut.

The front end of the onshore swap curve should now show a tendency to steepen. Amid speculation that major central banks are about to scale back quantitative easing programs, front-end KRW swap rates have already moved back above the 3M CD rate. While Korea’s weak economy is limiting the steepening potential of the Korean swap curve, the fear of higher interest rates in the advanced markets is obliging traders to price in more interest rate risk. As paying interest strengthens relative to receiving interest, the 1Y/3Y curve spread steepens. It has already moved back into positive territory to levels last seen in 2011.

If the USD yield curve continues to steepen to price in more Fed rate hike risk into the intermediate sector, the Korean yield curves will continue to be under steepening pressure. The front-end steepening should push up swap rates across the term-structure. Even weak economies, like Korea, will see curve steepening, as investors will expect their central banks to match Fed rate increases to keep interest rate differentials from narrowing significantly. It is through this expectation channel that a steeper dollar curve puts steepening pressure on Asian yield curves. Domestic economic weakness just means that curve steepening in the local market will be less extreme than in the USD market.

Bond yields too should be under upward pressure. However, sharp moves in the bond market are unlikely. The weak state of the economy significantly limits steepening potential and will keep the curve rather flat. Without significant front end steepening, longer-term KRW interest rates will not rise much. In other words, a sharp steepening of the U.S. Treasury curve is unlikely to lead to a correspondingly strong steepening in the KRW curves. As long as the economy shows clear signs of weakness, the propensity of the Korean curve to steepen in response to a steepening in the U.S. Treasury curve should be among the lowest in the region.

We expect yields on benchmark Korean Treasury Bonds to rise. Yields in the 3Y sector are likely to end 2H13 near 3% and yields in the 10Y sector are likely to end 2H13 near 3.75%

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Chart 7: O/N Call Rate, KTB 3Y & KTB 10Y Yield

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KTB 10Y Yield vs UST 10Y Yield

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If the USD yield curve continues to steepen to price in more Fed rate hike risk into the intermediate sector, the Korean yield curves will continue to be under steepening pressure

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Taiwan: Curve should price more, not less, interest rate risk

After a strong rebound in real GDP to 3.7% YoY in 4Q12, the 1Q13 GDP report disappointed with the annual growth rate falling to just 1.5%. In QoQ saar terms, the economy contracted by -3.2%. However, domestic demand overall is not weak, as evidenced by gross capital formation picking up and strong import growth reducing the contribution of net exports to headline GDP growth.

Barring any shock to confidence, interest rate risk is increasing with private sector activity. Private sector loan growth bottomed in 3Q12 and is likely to increase this year alongside stronger investment activity. If investment activity increases, the flow of credit to the private sector will increase too and the annual growth rate in credit will pick up from levels around 2.5% in the past several months. The low level of real fixed investment to GDP suggests that there is ample room for improvement. The current real investment rate is not much higher as during the crisis months of 1H09 and 2H11.

In addition to stronger domestic demand and faster credit growth, movements in the USD curve have the potential to lead to significant steepening pressure in Taiwan. Given the extremely low levels of short-term rates in both countries, a scenario in which only the dollar curve steepens and interest rate differentials widen sharply is very unlikely.

With these dynamics, the TWD swap curve should exhibit a steepening bias, not a flattening bias. The 5Y swap rate could easily rise to 1.4% in the coming months from 1.12% on 30 May and a low of 0.89% on 25 July last year. The 1.4% level was last seen in May 2011, before the acute phase of the European debt crisis.

The benchmark 2Y/10Y government bond curve too should exhibit a steepening bias. In fact, the curve spread is likely to widen to 100bps, entering the range it inhabited in 2009 and 2010. It reached 70bps in May from lows near 40bps in mid-2012.

To be clear, while private sector activity should pick up, we don’t think it will be strong enough to oblige policymakers to raise borrowing costs in the next several months. For now, the Central Bank of China should keep its main policy rate, the discount rate, unchanged at the 1.875% level it has been at since June 2011.

We expect yields on benchmark Taiwan government bonds to rise. Yields in the 2Y sector are likely to end 2H13 near 0.9% and yields in the 10Y sector are likely to end 2H13 near 1.7%

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Chart 10: Disc. Rate, TWD CP 3M & Onshore Swaps

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In addition to stronger domestic demand and faster credit growth, movements in the USD curve have the potential to lead to significant steepening pres-sure in Taiwan

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Thailand: Procyclical monetary policy should not turn more procyclical

The Bank of Thailand lowered its key policy rate, the 1-day repo rate by 25bps to 2.5% on 29 May. While credit growth is a concern, domestic aggregate demand growth is strong and the current account is weak, the strong Baht gave the central bank room to lower rates. After political pressure on the central bank intensified and major central banks around the world undertook another round of easing, the rate cut did not come as a surprise. Talk about capital controls and rate cuts had intensified in April and early May and the onshore swap curve had moved lower to price in a rate cut well before the actual rate action.

With the Baht weakening, the rate cut should be a one off. Given the combination of strong domestic demand and weak external demand, rate cuts are not a good idea from a forward-looking, longer-term point of view. Procyclical monetary policy should not turn more procyclical as it risks pushing Thailand’s current account position into deficit.

On the external front, the external demand environment is likely to improve, but it is unlikely to improve enough to accommodate strong domestic demand growth. On the domestic front, macro-prudential measures are unlikely to play a large enough role to cool overall domestic demand. The trade balance is already in deficit and if the current account goes into deficit, the country will become more dependent on capital account surpluses and therefore vulnerable to swings in risk appetite and capital flows.

While some adjustments to the balance between domestic and external growth is currently taking place through currency depreciation, the underlying case for higher interest rates is getting stronger. This will become clearer in the coming months when strong domestic demand continues to take a toll on current account and the Baht’s fundamentals continue to weaken.

What does all this mean for rates? The FX-implied 6M THBFIX, which serves as the swaps’ floating leg fixing index, moved sharply lower in late April, anchoring the swap curve lower. With onshore dollar liquidity conditions good, this was clearly because of rate cut expectations not because of FX factors. As the rate cut was priced in when it was delivered and clearly seen as a one off adjustment, the swap curve was quick to re-steepen. The 2Y/10Y government bond benchmark yield curve showed the same behavior and is likely to continue to steepen.

We expect yields on benchmark Thailand government bonds to rise. Yields in the 2Y sector are likely to end 2H13 around 3% and yields in the 10Y sector are likely to end 2H13 above 4% (breaking out of their 3-4% range)

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With domestic demand growth remaining strong, the underlying case for higher interest rates is getting stronger

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Malaysia: More of the same range-bound behaviour for now

Economic growth figures unexpectedly disappointed in 1Q13, with the annual growth rate in real GDP falling to 4.1%. This is the lowest annual growth rate since 3Q09. However, the weak number primarily reflects weakness in the external sector and the government sector. Private domestic aggregate demand continues to expand at a healthy clip (private consumption is up 7.5% from a year ago and private investment 13.2%).

With domestic private sector activity expanding nicely, the weak headline GDP number does not translate into a case for easier monetary policy. The Overnight Policy Rate has been at 3% since May 2011 and is widely expected to remain at 3% in the coming months. As long as this is the case, intermediate-maturity MYR swap rates will continue to trade sideways above 3M Klibor and in the upper half of the ranges they have inhabited since September 2011.

Especially, the 1Y swap rate, since December last year, has been very stable around the 3.2% level of 3M Klibor. This means that players in the onshore rates market have seen neither pressures for rate hikes nor rate cuts. This is in stark contrast to the period from mid-2011 to mid-2012, when the 1Y swap rate traded mostly below 3M Klibor.

That said, rate hike risk is slowly increasing, because domestic demand is fairly strong relative to external demand and the US economy continues to improve. Tighter monetary policy is becoming more likely, despite the fact that the annual CPI inflation rate is low (1.7% in April) and monetary aggregates are expanding in line with their recent underlying trends. Credit growth in year-on-year terms was 10.6% in March and the annual growth rate in M3 stood at 9.05%. The rates market has started to reflect this by no longer pricing in any chance of rate cuts into the 1Y sector. The next step will be to price more rate hike risk into the intermediate sector.

To be clear, rate action is not imminent, but the risk is for policy interest rates to be hiked at some point soon, which is not at all priced into the yield curve. For the swap curve that means steepening pressure as the forward path for policy rates is more likely to steepen than flatten. However, in the near-term that pressure is unlikely to be strong and swap rates should continue to trade sideways in the upper half of their respective ranges before any breakout on the top side amid intensifying rate hike speculation.

We expect yields on benchmark Malaysian government securities (MGS) to rise. Yields in the 3Y sector are likely to end 2H13 around 3.2% and yields in the 10Y sector are likely to end 2H13 around 3.6%

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Chart 14: Policy Rate, 3M Klibor & MYR IRS

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as of 27 May 2013

The Overnight Policy Rate is widely expected to remain at 3% in the coming months. As long as this is the case, intermediate-ma-turity MYR swap rates will continue to trade sideways above 3M Kibor

46


Indonesia: Tighter monetary policy ahead

The rupiah continues to weaken and the annual headline CPI inflation rate is no longer comfortably within the central bank’s 3.5-5.5% target range. It’s time for Bank Indonesia to hike rates. Domestic demand growth is relatively strong compared to external demand growth, putting pressure on external balances. These in turn are putting pressure on the rupiah and domestic liquidity conditions. As long as Indonesia can attract enough capital to cover the shortfall on the current account, all this is manageable, but capital flows are volatile and conditions to attract capital are not always favourable.

As policy focus shifts from growth to stability, Bank Indonesia signaled in May its readiness to tighten monetary policy and shortly thereafter hiked the FASBI deposit rate by 25bps to 4.25% on June 12. After years of policy easing, that is big news. It means that the central bank will focus on containing domestic demand, inflationary pressures and currency volatility.

Tighter policy is prudent to preserve the economic gains of the past years by helping stabilize the internal and external exchange value of the rupiah. It is desirable even if it leads to a repricing of interest rate risk in the domestic government bond market (it clearly means upward pressure for yields as the yield curve is not discounting rising short-term rates appropriately yet). With yields moving on an upward trajectory currently, this process has started and it should continue for a while.

We think that short-term interest rates, like the FASBI deposit rate (currently 4.25%) and 3M Jibor (currently 5.13%) will rise 200bps over the coming 12-18 months to return to 2010 levels. That would put yields on 2Y domestic government bonds at around 7% and yields on 10Y domestic government bonds at around 8.5% by the end of 2014. Yields will not instantaneously jump to these levels from the current 4.66% and 5.92% respectively, but they should be under upward pressure in the coming months and end the year clearly higher. If the FASBI deposit rate is lifted 50-100bps in 2H13, they are likely to end the year around to 6% in the 2Y sector and 7.5% in the 10Y sector.

Moreover, an increasing government budget deficit will result in more government paper being issued, which should put steepening pressure on the yield curve. More paper will have to be absorbed by the banking sector as foreign entities and the non-foreign non-bank sector are unlikely to expand positions as strongly in a bear market as in a bull market.

We expect yields on benchmark Indonesian government bonds to rise. Yields in the 2Y sector are likely to end 2H13 around 6% and yields in the 10Y sector are likely to end 2H13 around 7.5%

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The rupiah contin-ues to weaken and the annual head-line CPI inflation rate is no longer comfortably within the central bank’s 3.5-5.5% target range; it’s time for Bank Indonesia to hike rates

47


Philippines: Liquidity overhang

Persuaded by a strengthening external profile, moderating inflation, and the government’s declining reliance on foreign currency debt, Standard & Poor’s in May raised the rating on the Philippines’ long-term foreign-currency-denominated debt one level to BBB- from BB+, with a stable outlook.

Essentially, the rating agency is saying that macro-economic fundamentals have improved and that this is translating into higher creditworthiness of the government. This is not surprising as structural balance of payments flows in the form of sustained streams of remittances are keeping the current account in surplus despite a trade deficit and strong trade-weighted real appreciation of the peso of more than 50% since 2004.

As the capital account too is in surplus, the balance of payments is generating substantial onshore USD liquidity and (through FX intervention) PHP liquidity in the domestic banking system. Last year, the Philippines experienced one of the largest percentage increases in reserves within Asia despite one of the largest nominal exchange rate moves against the US dollar.

Large persistent inflows of capital are a pleasant problem as they provide banks with ample liquidity to extend credit and allow the central bank to build reserves to meet future portfolio outflows. However, substantial liquidity in the banking system is not all good news. It complicates the conduct of monetary policy as it weakens the link between policy and market rates.

In the Philippines, this has clearly been an issue since 2010, as evidenced but the large trading range for interbank rates and the low level of government bond yields relative to the policy rate corridor. Especially since late 2010, market rates have been disconnected from policy rates as a liquidity overhang has weakened the transmission of monetary policy to market interest rates. As a result, overnight interbank rates are low and yields on government bonds (all the way to the 10Y sector) are trading around the level of the reverse repo rate.

Ample liquidity in the banking system at the moment has more impact on the level of market interest rates than policy interest rates. For as long as this is the case, yields on government bonds can stay at record lows. Both PHP and USD liquidity in the banking system should continue to expand through surpluses on both the current account and the capital account. Therefore, the outlook for primary liquidity in the banking system remains favorable and that should mitigate steepening pressure coming from global benchmark yield curves, keeing the benchmark 2Y/10Y government bond yield curve fairly flat.

We expect yields on 2Y and 10Y benchmark Philippine government bonds to rise to around 3% and 4.5% respectively in 2H13

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Chart 17: USD/PHP & 3M Money Market Rate

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The outlook for primary liquidity in the banking system remains favorable and that should mitigate steepening pres-sure coming from global benchmark yield curves, kee-ing the benchmark 2Y/10Y govern-ment bond yield curve fairly flat

48


India: Scope for further rate cuts is limited

Indian Gilt yields have been under noticeable downward pressure after rate cuts in May took the reverse repo rate to 6.25% and the repo rate to 7.25%. The 10Y Gilt yield has fallen to levels near its 10Y average of around 7.3%, but there is limited scope for a continuation of the rally. We think that the RBI will probably deliver at most one more rate cut this year, and that only if the global financial market environment stabilizes soon. In any case, the repo rate sets the floor for the 10Y Gilt yield around 7%.

There remains a structural liquidity deficit in the banking system, as evidenced by sustained high bank demand for repo transaction with the Reserve Bank, and that makes it difficult for yields to fall. With a cash shortage, we doubt that buying pressure in the Gilt market will be strong enough to push the 10Y Gilt yield significantly below the repo rate. And the repo rate is unlikely to continue to fall rapidly.

While the annual WPI inflation rate has fallen to below 5% and the rupee is stable at the moment, scope for further rate cuts in India is limited. Reducing the risks to macroeconomic stability that stem from the weak balance of payments position remains one of the central bank’s key monetary policy priorities. Improvements in the current account are necessary to make India less dependent on capital flows and less vulnerable to swings in global risk appetite.

More specifically, until the balance of payments position improves and produces more liquidity on a sustainable basis, banks will not be in a strong position to extend credit. With a liquidity deficit in the banking system, there is no scope for a strong flow of credit to the productive sectors of the economy. As a result, there is no scope for a sharp rebound in investment driving a sharp rebound in growth.

The current account deficit, rupee weakness, inflation and growth are all linked through banking system liquidity. Ultimately, growth needs credit and credit needs liquidity. If the latter is not produced by the balance of payments, we have a problem.

Liquidity expansion through permanent open market purchases of government bonds by the central bank is possible but it cannot be substantial. It would weaken the rupee. Healthy liquidity expansion has to come from a stronger balance of payments position. With this, we think that yields on government bonds can only fall with cuts in the repo rate for now, but scope for cuts in the repo rate is limited.

We expect yields on 2Y and 10Y benchmark Indian government bonds to fall to around 7% in 2H13, paced by cuts in the RBI’s policy repo rate

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Yields on govern-ment bonds can only fall with cuts in the repo rate for now, but scope for cuts in the repo rate is limited

49


China: Towards healthier growth

After 7.9% year-on-year real GDP growth in 4Q12, which marked a rebound from a seven-quarter slowdown, China disappointed with 7.7% growth in 1Q13. It now looks like the growth pace this year will be a lot closer to last year’s 7.8% (the weakest in 13 years) than 2011’s 9.3%. Whatever the number, China is in for a period of moderately fast growth.

The GDP report was not all disappointing though. As service industries contributed more to economic growth in 1Q13 than manufacturing, it signals an important achievement in light of current efforts to get off the capital intensive industrial growth model of the past ten years.

In line with these, further interest rate liberalization, capital account convertibility and exchange rate reform remain at the top on China’s reform agenda. The Chinese yuan fixing fell below 6.17 against the dollar in early June and further exchange rate liberalization should mean CNY appreciation, given the country’s trade competitiveness.

China is phasing out the policy of keeping the renminbi undervalued and markets should expect this to mean that China is also ending the policy of underpricing capital through further interest rate liberalization. While some steps have been taken in this direction, China still needs to close the wide gap between return on capital and cost of capital to reduce incentives for investment.

The People’s Bank of China sets a ceiling on deposits and a floor on lending rates, to bring about a spread and more importantly a low overall level of cost of capital relative to the return on capital. This has been helpful in supporting the investment driven growth model of the past, but it is harmful now that reliance on investment should be reduced. Hence, the need for interest rate liberalization.

With interest rate liberalization widely expected lead to higher deposit and lending rates, the Chinese leadership’s new focus on slower and more balanced economic growth should not be expected to lead to lower interest rates. Lower economic growth does not mean lower interest rates. For the government bond market that means that there is no room for a sustained rally. Interest rates might fall before they rise, but there is unlikely to be a substantial period of low short-term interest rates.

We expect yields on 2Y and 10Y benchmark Chinese government bonds to be rise to 3.5% and 4% in 2H13

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Chart 21: China's Policy Rates & Reserve Ratio

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With interest rate liberalization widely expected lead to higher de-posit and lending rates, the Chinese leadership’s new focus on slower and more bal-anced economic growth should not be expected to lead to lower interest rates

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Interest rate forecasts%, eop, govt bond yield for 2Y and 10Y, spread bps

12-Jun-13 3Q13 4Q13 1Q14 2Q14

US Fed Funds 0.25 0.25 0.25 0.25 0.253m Libor 0.27 0.30 0.30 0.30 0.302Y 0.33 0.78 0.78 1.17 1.1710Y 2.23 2.75 3.00 3.25 3.5010Y-2Y 190 197 222 208 233

Japan O/N Call Rate 0.10 0.10 0.10 0.10 0.103m Tibor 0.23 0.25 0.25 0.25 0.25

Eurozone Refi Rate 0.50 0.50 0.50 0.50 0.503m Euribor 0.21 0.19 0.19 0.19 0.19

Indonesia BI Reference Rate 5.75 5.75 5.75 6.00 6.253m Jibor 5.16 5.50 5.75 6.00 6.252Y 5.78 5.50 6.00 6.50 6.7510Y 6.51 7.00 7.50 8.00 8.2510Y-2Y 74 150 150 150 150

Malaysia O/N Policy Rate 3.00 3.00 3.00 3.00 3.003m Klibor 3.21 3.25 3.25 3.25 3.253Y 3.15 3.20 3.20 3.20 3.2010Y 3.46 3.60 3.60 3.60 3.6010Y-3Y 31 40 40 40 40

Philippines O/N Reverse Repo Rate 3.50 3.50 3.50 3.75 4.003m PHP Ref Rate 1.55 1.50 2.00 2.75 3.002Y 2.72 2.75 3.00 3.25 3.5010Y 3.54 4.25 4.50 4.75 5.0010Y-2Y 82 150 150 150 150

Singapore .. .. .. .. .. ..3m Sibor 0.37 0.35 0.35 0.35 0.352Y 0.28 0.40 0.40 0.46 0.4610Y 2.19 2.10 2.25 2.35 2.5010Y-2Y 191 170 185 189 204

Thailand O/N Repo 2.50 2.50 2.50 2.50 2.753m Bibor 2.60 2.60 2.60 2.60 2.852Y 2.83 2.70 3.00 3.00 3.2510Y 3.97 3.80 4.25 4.25 4.5010Y-2Y 114 110 125 125 125

China 1 yr Lending rate 6.00 6.00 6.25 6.25 6.501yr deposit rate 3.00 3.00 3.25 3.25 3.502Y 3.09 3.25 3.50 3.75 3.7510Y 3.46 3.75 4.00 4.25 4.2510Y-2Y 37 50 50 50 50

Hong Kong .. .. .. .. .. ..3m Hibor 0.38 0.40 0.40 0.40 0.402Y 0.25 0.83 0.93 1.32 1.3210Y 1.62 2.10 2.60 2.85 3.1010Y-2Y 137 127 167 153 178

Taiwan Discount Rate 1.88 1.88 1.88 2.00 2.133M CP 0.88 0.80 0.80 0.88 1.002Y 0.61 0.80 0.90 0.90 0.9010Y 1.34 1.60 1.70 1.70 1.7010Y-2Y 73 80 80 80 80

Korea 7d Repo 2.50 2.50 2.50 2.75 2.753m CD 2.69 2.70 2.75 3.05 3.053Y 2.88 2.85 3.00 3.25 3.5010Y 3.31 3.50 3.75 4.00 4.2510Y-2Y 43 65 75 75 75

India 1d Repo 7.25 7.00 7.00 7.00 7.003m Mibor 8.46 8.00 8.00 8.00 8.002Y 7.41 7.00 7.00 7.00 7.0010Y 7.30 7.50 7.50 7.50 7.5010Y-2Y -11 50 50 50 50

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52

Economics–Markets–StrategyCNH

Nathan Chow • (852) 3668 5693 • [email protected]

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CNH: Becoming a global player

History suggests that the international acceptance of a currency goes hand in hand with the country’s economic power. As the US economy expanded after World War II, for instance, the dollar overtook the once-ruled British pound as the international reserve currency. The Japanese yen was also internationalized after Japan emerged the world’s 2nd largest economy in the 1970s.

If history is any guide, the internationalization of the RMB is long overdue. Currently, China represents around 11% of global GDP (2nd largest economy) and more than 10% of world trade (largest trading country). Alas, China is the only one amongst the world’s six largest economies whose currency is not a reserve currency.

Moving up fast

Since the launch of the RMB cross-border trade settlement pilot scheme in 2010, the proportion of China’s trade settled in RMB has surged six-fold to 12% (Chart 1). As a global payments currency, the growth of RMB has far outpaced that of most currencies. In March, RMB payments grew in value by 32.7%, in comparison to the average increase of 5.1% across all currencies. That brought its share in international payments to 0.74% (13th place) in Mar13 from 0.25% (20th place) in Jan12 (Chart 2). For corporations that trade with China, the use of RMB can lower their FX costs and risks. They can also enjoy the price discounts offered by some Chinese companies. Cost advantages would further fuel the future growth of RMB-settled trade. The emerging markets are expected to lead the charge in adopting the RMB due to China’s increasing share in their trade flows.

Aside from trade, there were other encouraging developments. RMB-settled outward direct investment ballooned 50% in 2012 (Chart 3). The outstanding dim sum bond market experienced multi-fold growth in the past few years. These developments affirmed that RMB is also increasingly becoming accepted for investment purposes, and not just for trade settlements.

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Cost advantages would further fuel the future growth of RMB-settled trade

• The RMB is increasingly being seen as a global currency

• Other offshore markets complementing Hong Kong’s central role are emerging around the world

• The accelerating pace of internationalization paves the way for Beijing’s ultimate goal of making the RMB a reserve currency

53

CNHEconomics–Markets–Strategy

Regionalization taking shape

Looking forward, the RMB use in trade settlement and investment payments will likely accelerate following Beijing’s recent moves. That includes the appointment of banks in Singapore and Taiwan to clear RMB-denominated activities. The outstanding of RMB deposits in Taiwan reached RMB60 billion in May, just three months after Taiwanese banks started to offer RMB accounts. Trading of offshore RMB-denominated bonds in Singapore had a strong and impressive start. Only a week after the kick-off of the clearing service, three banks (including DBS) collectively offered RMB2 billion worth of bonds that were quickly snapped up. That highlights not only the robust demand for RMB assets, but also Singapore’s excellent efficiency in handling RMB activities.

As we mentioned in our report “CNH: Singapore and Taiwan style, 19 Feb 2013”, Singapore has much to offer as an offshore RMB hub given its advanced financial infrastructure. With its geographical advantage, the city-state also provides a platform for Beijing to facilitate a wider use of RMB in China-ASEAN trade as well as “third-party” activities.

Calling from G7

Asia is doubtless a natural starting point for China to promote the international use of RMB due to its geographical proximity. That nevertheless does not prevent the other part of the world to seize the rapidly growing pie. The Bank of France recently announced that the authority will soon set up a currency swap line with the People’s Bank of China. Currently, RMB deposits in Paris amount to RMB10 billion and nearly 10% of Sino-French trade is settled in RMB. France is now ranked No. 4 in the world for RMB payments value (excl. Hong Kong and China), trailing behind the United Kingdom, Singapore, and Taiwan. Meanwhile, French companies are among the most active European issuers of RMB-denominated bonds. In 2011 and 2012, the total value of offshore RMB-denominated bonds issued by French corporates was nearly RMB7 billion.

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Chart 2: RMB ranks 13th as world payments currency (as of Mar13)

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Chart 3: RMB ODI surged 50% in 2012

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Singapore has much to offer as an offshore RMB hub given its advanced financial infrastruc-ture and geograph-ical advantage

54

Economics–Markets–StrategyCNH

Given France’s favorable geographical location and historical relationship with Africa, Paris can position itself as a hub for RMB trading in the Sino-African business. The launch of a currency swap line can foster the RMB use in such business flows. It will also boost market confidence by reassuring participants that RMB liquidity will remain available even in extreme conditions.

Hong Kong market deepening

Even whilst the RMB was broadening its appeal globally, Hong Kong continued to deepen the development of its CNH market – the primary offshore RMB center. The Treasury Markets Association recently announced the launch of CNH HIBOR fixing. This will provide a reliable benchmark to price loan facilities and facilitate the development of the offshore RMB interest rate swap market. Meanwhile, banks’ net open positions and statutory liquidity requirement for RMB have also been lifted. Given the loosening of lending restrictions, the demand for offshore RMB financing activities is expected to become more robust going forward. That reinforces the 1Q13 finding of our DBS RMB Index for VVinning Enterprises (DRIVE), in which some corporates shown great interest to take out RMB loans in the next 12 months.

Several developments were also seen in the RMB repatriation system. In particular, the quota for the RMB Qualified Foreign Institutional Investor (RQFII) scheme was expanded by RMB200 billion to RMB270 billion. The cross-border lending pilot scheme was also launched, enabling Qianhai companies to borrow RMB loans from banks in Hong Kong. We look forward to the further streamlining of policy arrangements so that the circulation of RMB fund flows between the onshore and offshore markets can be facilitated to a greater extent. Potential initiatives include allowing Qianhai companies to directly issue dim sum bonds in Hong Kong and allowing mainland individual investors to participate in the RQDII (RMB-denominated version of Qualified Domestic Institutional Investor) program.

Conclusion

As the offshore market broadens and deepens simultaneously, the RMB is set to move up the ranks rapidly as a global payments currency. Ongoing interest rate liberalization and other financial reforms in the mainland will pave the way for Beijing’s ultimate goal of making the RMB a reserve currency. In 2015, the International Monetary Fund will review the composition of the basket of currencies it uses to define the Special Drawing Rights (SDR). The likelihood of RMB to join the club of dollar, euro, pound, and yen is reasonably high.

Continuous mar-ket development is also seen in Hong Kong

55

CNHEconomics–Markets–Strategy


56

Economics–Markets–StrategyAsian Equity Strategy

Joanne Goh • (65) 6878 5233 • [email protected]

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Asia equity: Wary but hopeful• Thenear-termrecommendationforequitiesistobuyonweakness.Weexpect

another10%downsidefromcurrentlevelsasthemarketstrytopriceinUSbondyieldsof2.5%-3%.USbondyields,hoveringnear2.2%afterrisingfrom1.6%,istradingtowardstheupperendoftherangefornow.Weexpectyieldstofallandtriggerareboundinequitiesinthenear-termconsideringthecheapequityvaluations.QEtaperingisunlikelytostartuntilDecember,butregardless,QEexitshouldbepositiveforequitiesasbondfundsshifttoequities

• The challenge is to look for sectors which will benefit from this shift.As recoverywill bemodest, buying cyclicalsmaynotbe a surewin,whileovercrowdedinvestorspositionsindividendplaysandREITshaveheightenedriskofprofit-taking.Werecommendinvestorssearchforbalanceingrowthandvaluebyfocusingonsectorswiththematicsupport

• Onamediumto longer termhorizon, risingbondyieldsand recovery isamatteroftime.Butvolatilitywillpersistasthesetwocouldmoveatdifferentpaces and expectations change over time.Macro uncertainty portends tobroadmarket volatility. Investors shouldhedge inpositionswhich are lesssensitivetomacrouncertaintybyfocusingondomesticdrivers,suchasthosein ASEAN and mid-small caps, until there are signs of a stronger globalrecovery.WatchforimpactofUSsequestration,Eurozonerecovery,Japan’seconomicrestructuringplan,andFed’sforwardguidance

Source:Datastream,DBS

Fig. 1: High yields bonds and Asia equities performance

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Asian Equity StrategyEconomics–Markets–Strategy

Global markets took their cue from policy support in the 1H

WorldequitiesstagedarallyinNovemberlastyearonperceivedlimiteddownsiderisks.USpolicyaccommodationandECB’sbackstoptodoeverythingnecessarytopreservetheeuromitigateddownsiderisksonaUSrecessionscenarioandeurozonedisintegration.Indeed,marketshavestayedresilienttoUSmacroeconomicweaknessandeurozonetroublesthroughout1H.

Global optimismwas given another boostwhen Japan set out on an ambitiousmonetary easing and stimulus programme in January. JPY/USD had depreciatedfrom80tonear105,fuellingyencarry liquiditytrades.ByearlyMay, inflationinmany countries has fallen sharply, thus opening the door for additional easing.ManycentralbanksinEurope,AustraliaandAsiahadcutpolicyratesby10-100bps,reflectingaccommodativepolicybias, andworldequitieshad reachednewpost-crisishighsby21May.

Lingering uncertainty

During the period, prospects for the global economy remained uncertain. HighfrequencyUSdatashowedmixedsignals:USconsumption,housingdata,andjoblessclaimsshowedmixedrecovery,whilePMIdatafaltered.ImpactofUSsequestrationhasyettobereflectedinthesenumbers.InAsia,exportsandPMIdataweremostlynegative,leadingtodisappointmentsandcutsineconomicgrowthforecasts.Thepresumption thatweak global growthwould continue to attract policy supportdrovemarkets higher. Early optimism that Chinawould boost FAI spending andliftgrowthabove8%this year fadedas theproposed reforms seemedboldandexecutionwouldbethekeyrisk,anddetailsofhowtheywillbecarriedoutwillonlybeavailableinNovemberattheNationalCongressmeeting.Likewise,JapanesePMAbe’s“thirdarrow”ofstructuralreformstoboosttheeconomyontopofmonetaryandfiscalstimuluspolicieswasviewedasshortondetails,butdraftingofspecificdetailsmightgainspeedaftertheUpperHouseElectionsinJuly.

Trial run on QE exit

InlateMay,investorshadatasteofpossiblemarketreactionstoQEtapering.ThiscameaboutafterthereleaseofFedmeetingminutesthatshowedsomememberswerewillingtostartrollingbackbond-buyingprogramsasearlyasJune.USbondyieldsrosefrom1.6%to2.2%,DXYappreciated4.5%,andworldequitiescorrected6%fromthehigh.Riskassetslikeemergingmarketbonds,currenciesandequities,commodities and junkbonds, also corrected, asdiddefensiveandhighdividendyieldplays.

It seemsFed isadjusting its forwardguidance,andthuspreparingthepublic foreventualratehikes.ButwhetherFedwillactuallyraiseratesbeforeorafter2015isunimportant.Thepublicwassurelycaughtoff-guardbyFed’sinconsistency.

Consolidation inconsistent with a recovery theme

We believe the current correction beginning in late May / June is due to anadjustmentinperception,aswellasthefearofaprematureQEexit.Thecorrectionwasexcessiveand inconsistentwitharecoverywhichshouldbenefit riskassets ifthereisone.

OurhouseviewremainsthatUSrecoveryisstillweakandtheimpactofthe$85bnsequester cuts – which hit in Apr-Sep – has yet to be reflected in the broadereconomy.ThelatestISMdataof49.0inMaysupportsthat;theorderscomponentdroppedby3.5pointsto48.8,suggestingareboundisunlikelynextmonth.QE3maybearoundforabitlonger,andhence,bondyieldsarenotrisingmuchfromcurrentlevelsfornow.

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Rising bond yields and recovery moving at differ-ent paces causing volatility

Theconsequentialriseinbondyieldshavedriveninvestorstotakeacloserlookatrisksvsthebondmarketswhereyieldshavebeenkeptartificiallylow,inourview.Itisonlyamatteroftimethatinterestrateswillriseanditisprudenttobepreparedforit.MarketsarenowlookingforQEtaperingbySeptemberandFedraisingshortrate inMarch2015.Changes inexpectations for these twovariableswillbe themainsourceofmarketvolatility.InvestorsshouldkeeptrackofmajorFedeventsinthesecondhalftohedgevolatilityaroundthesedates.

WeexpectthecurrentcorrectiontofindsomestabilitybythenextFOMCmeetinginJune18/19.Asof11June,Asiaex-JapanmarketstradebelowaverageP/B,andsouth-eastasiamarketstradearoundaveragere-ratedP/Blevels.Webelievethattail risks drivenby aglobal recessionor a eurozonemeltdownhavediminishedandhenceequitiesshouldfindsupportataveragelevels.ThestructuralchangesinASEANshouldcontinuetosupportthere-rating.(Fig.2,3)

Lessons to be learnt from the trial run

Rising bond yields are not positive for yield plays

Marketsarelikelytobeunderpressurewhenbondyieldsnextrise.BasedontheFed’scurrentexpectationsofthespeedoftherecovery,US10-yearbondyieldwillriseto3%byendofthisyear,accordingtoDBSfixedincomestrategist.Weexpectyield plays to beunder pressure. Investors should stress-test yield playswithUSbondyieldsrisingto3%beforeanyentrylevels.

Theoreticallyifthecurrentpriceisfairandnotpricinginanyyieldriseyet,a5%yieldingstockshouldcorrectby17%toearnthesameyieldspread.Thetableonthenextpage(Fig.4)showstheyieldandpricesensitivity,whichclearlyshowspricecompressiontocompensatefornarrowerspreads.Investorsshouldfocusonhighyielding,andpotentiallygrowingyieldstocksforpricetolerance.

Not 1994

Thetrial runtestedascenariowhenUS interestratesroseunexpectedly in1994andequitiesmarketunderperformedforthewholeof1994whenthebondmarketcrashed. Comparing now and then, unless we see a prolonged period of high

Fig.2:Asiaex-JapanequitiesP/B

Source:Datastream,DBS Source:Datastream,DBS

Fig.3:AseanequitiesP/B

1.3

1.4

1.5

1.6

1.7

1.8

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2

2.1

Jan-10 Oct-10 Jul-11 Apr-12 Jan-13

(x)

1.5

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2.1

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Jan-10 Oct-10 Jul-11 Apr-12 Jan-13

(x)

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inflationfollowedbyconsecutiveFedratehikes,weareunlikelytoseearapidriseinthebondyields.

Infact,slowergrowthonthemarginhasallowedinflationtodriftlower.CoreCPIinflationhasfallento1.7%YoYasofApril.CorePCEinflation,whichistheFed’sfavoredgauge,hasdroppedtobarelyhalfofFed’stargetrate.

Unknown leverage exposure

The fear is theunknownonhowbig is themarket’s leveraged exposure to lowinterestratesconsideringtheliquiditywhichhasbeenpouredintofinancialassets.The rapid rise on housing prices in Asia, emerging markets bonds and globalcorporatebondsshouldremindinvestorstobeprudenttopreparefortheeventualriseinbondyields.

QE tapering is not QE exit

InthepreviousQEs,equitiesmarketswerealsosubjecttohighvolatility-nervousbeforetheirexit,andcheeredwhentheywerefollowedbynewQEprogrammes.Fedthencameupwith“QEinfinity”inSeptemberlastyearwithnoscheduleandexpanded theamountbyUS$45b inDecember. Fedhas also communicatedonlyveryrecentlythatQEcouldbeexpandedandreducedatanytime,dependingoneconomicconditions.Publicwillsoongetusedtothis“elasticity”,sotospeak.

IfQE starts tapering, it should not be viewed as aQE exit.We believe FedwillcommunicateveryclearlythattheeconomyisstrongenoughandQEsupportisnomorenecessaryifthetimecomes,therebyliftingtheglobalcyclicaloutlook.MarketcurrentlypricedinafirstratehikeinMarch2015.DBSchiefeconomistbelievesthattheriskisthathikescomelaterandnotsooner.

3Q strategy

We believe there are support at current levels as the markets are trading nearaverageP/Blevels.Marketsshouldreboundinearly3QfollowingtheMay/JunecorrectionandvolatilitywhichweexpecttolastthroughtoendJune.Basedonfig.5,AsiacurrentDYistradingbelowfair,notsurprisinggiventhesearchforyieldstradeinthepastoneyear.MarketswouldhavepricedinUS10-yearbondyieldsat

Fig.4:Pricesensitivitytoyields—dropinsharepricewhenbondyieldrisesbydifferentlevelsforstockstradingatdifferentyieldlevels

Source:Datastream,DBS Source:Datastream,DBS

Fig.5:AsiaDYminusUS10-yrbondyieldyieldgap,fairvsactual

Rise in bond yields

Current DY 0.50% 1% 1.5% 2.0%

8.0 -6% -13% -19% -25%

7.0 -7% -14% -21% -29%

6.0 -8% -17% -25% -33%

5.0 -10% -20% -30% -40%

4.0 -13% -25% -38% -50%

3.0 -17% -33% -50% -67%

2.0 -25% -50% -75% -100% -4

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(%)

fair levels based on US bond yield levels

DY yield gap

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2.5%-3%,aftera20%drop.Thereboundwillbedrivenby:-

a) USbondyieldshavingrisenfrom1.6%to2.2%,thestrategyteambelievesthatitisnowtradingattheupperendoftherangeintheneartermandshouldfall.TheFed’srhetoriconpossibleearlyQEtaperingshouldcometoatemporaryhaltintheJunemeetings.USdataisunlikelytobestrongenoughtobringforwardarecoveryview.

b) Fundamentals in Asia economies have not changed during the 2 weeks ofcorrection.Infactsomeheathasbeentakenofftheexternalbalance,especiallyinThailandandPhilippinesduetopriorstrongforeigninflows.ForIndonesiawebelievethemarketispricingintheweakeningcurrentaccountbalancewhichisalsocausedbythefuelpricesubsidy.Theimpactfromthefuelpricehikeswhenitisannouncedwillbelessonthemarketafterthiscorrection,inourview.

Havingsaidthat,marketsarelikelytobeunderpressurewhenbondyieldsnextrise.Thetusslebetweenworriesandhopesshouldkeepmarketsvolatile.BasedonourhouseviewthatQEtaperingwouldcomelaterthansooner,anyweaknessisabuyingopportunity.

Ontheflipside,theQEexitshouldbenefitequitiesasawhole,asbondfundsshouldshifttoequityfundsas investorsseekhigherreturns ingrowthassetclasswhentheyfeelmoreconfidentontheeconomy.Howeverunlessweseea sustainablegrowthrecovery,the“greatrotation”isunlikelytohappenfornow.

Equities still has room for P/E expansion

Asiaearningsyieldgapstillhasroomtocompress.Ourcalculationsshowthat ifbondyieldsriseto3%,Asiaequitieswillstillbedeemedcheap(+1SD)byyearendwhenthemarkettradesatFY14P/Emultiple.P/Estillhasroomtoexpandby21%beforeitisdeemedtooexpensive(belowaverage).

Ascenariowhererisingbondyieldsdonotcorrespondwithasustainablerecoverymeansthat themarketwillbevolatilewhenbondsyieldsandrecoverymoveatdifferentpaces,makingitachallengetolookforsectors.

Asrecoverywillbemodest,buyingcyclicalsmaynotbeasurewin,whileovercrowdedpositionsindividendplaysheightenriskofprofit-taking.Werecommendinvestors

Fig.6:US10-yearbondyields

Source:DatastreamSource:Datastream,DBS

Fig.7:Asiaex-JapanearningsminusUS10-yrbondyields

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02 03 04 05 06 07 08 09 10 11 12 13

(%)

Equity is cheap

Equity is expensive

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searchforbalanceingrowthandvaluebyfocusingonsectorswiththematicsupport.Theseinclude:

1)ASEANdomesticdemand;

2)Myanmarreforms;

3)UnlockingvalueinMalaysia’spropertysector;

5)China’sITsoftwareongovernmentreform;

6)China’slowcosthandsetand4Gequipmentvaluechain;

7)China’surbanisation

8)valueinREITSwhenthedustsettles;

9)UShousingrecovery

10)Japan’sreflation

Asset allocation

For the coming quarter we are making several changes to our marketrecommendations.Ourmainconsiderationarelookingformarketsthatwillseeastrongreboundfromthecurrentsell-offandpotentiallyreachanothernewhighin12-months’time(henceoverweight),andweakmarketswhichare likelytobetrappedinarange(henceunderweight).Neutralmarketsarelikelytoseeareboundbacktoprevioushighinthenext12months.

Ourmarketrecommendationsare:

i)OverweightsinIndonesia,Philippines(previouslyneutral);

ii)UnderweightsinIndia,Korea,Taiwan(previouslyoverweight);

iii)Neutral in Singapore,Malaysia (previouslyunderweight), Thailand (previouslyoverweight),HongKong/China(previouslyoverweight).

WebelievethatChinaisunlikelytosurpriseontheheadlineinthe3Qasitpursuesbold reformswhichmay take time to execute and sacrifice some of the shorterterm growthwhich themarketswere having high expectations previously. DBS’economisthasdowngradedourGDPgrowthfrom9%to8%but it is stillhigherthanthegrowthinQ1.

Besides,executionrisksarehighanda“systemoverhaul”maybeneededasreformsare targeted at someof the government controlled sectors like finance, energy,telecomsandrailtransportation.Majormarketheavyweightsectorslikefinancialsandenergystocksareunlikelytoseesustainablegainsinourview.

We are downgrading Thailand to Neutral. Q1 GDP surprised on the downsidewhichreflectedthattheeconomyisstillverymuchexportdependent,andstrengthin domestic demand is not enough to offset external weakness. High hopes oninvestment todrivegrowthmaybemetwithdisappointmentsasexecution risksarehigh.One, the amountof fundingmay stress the financial system if it is onlocalfunding,andifforeignfunded,couldriskexternalaccountstability.Secondlypoliticalvolatilitycouldsurfaceandaddtouncertaintyontothebudgetspendingrequiredfortheseprojectsespeciallywhenthericepricepledgehasalreadybeenpoliticised. Again on politics, near term risks could surface if the governmentpusheshardfortheamnestybill.Theweakexternaldemandoutlookandstrongdomesticdemandcouldeventuallydrivethecurrentaccounttoadeficitposition.Wearemaintainingneutralonvaluationsandstrongdomesticliquiditytodrivethereboundbutmarketmaybemorevolatilegoingforward.

Among ASEAN we have Indonesia and Philippines as overweight. Favourable

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demographics and strong income growth are supporting the domestic demandsectors.ForIndonesiatheneartermoverhangwillbethefuelpricesubsidywhichwebelievethemarkethaspartiallypricedinthecurrentcorrection.FundamentalsinPhilippineshavenotchanged andare stillas strongover the last twoweeksbutvaluationshavebecomecheaper.PhilippinesQ1GDPgrowthsurprisedontheupsideandevenexceededChina’s.WebelievethisisduetothepoliticalstabilityinrecentyearswhichhaveattractedalotofFDIinflows.Domesticliquidityisstrong.

TheothertwoASEANmarketsareSingaporeandMalaysiawhichwehaveneutralrecommendations.Malaysia seemsdefensive at this timeof volatility.We raisedittoneutralaselectionsuncertaintyisremoved.ETPbeneficiariessuchasbanks,property,constructionandoil&gasaresectorswhicharelikelytosustaininvestorinterestsaftertheinitialpostelectionseuphoria.Moreoverwedon’tseesimilarselloffinMalaysiareitsasinSingaporereitsasthesectorislesseroverowned.

Singapore ismaintained at neutral aswe see a better second half in economicgrowth,thusalleviatingsomeoftheconcernsondomesticeconomicfatigue.Therecentcorrectionhasdriventhemarkettobelowaveragevaluationsandweexpectareversalbacktoaverage.

WerateTaiwanandKoreaasunderweightsaswebelievetheexternaldemandisunlikelytopickupsoon.ForIndiatheriskofaratingsdowngradearegrowingasthecurrentaccountdeficithasexpandedagain followingexportsweaknessandevidentlygovernmentmeasuresarenotworkingtosolvethetwindeficitissue.

Market outlook

China

DBS;ChinaeconomisthasdowngradedgrowthforecastforChinato8%from9%.The strategy team believes thatmarket sentiments will be less affected by theheadlineas lowexpectationshavebeenpriced in.Marketfocushasnowturnedtohow thenew leadership is going toexecute reformplans to achieveamorebalancedandthussustainablegrowthpath.Untilthereareconvincingsignsthatthere is a strongpoliticalwill to carry out these plans,wedonot expectmuchupsidesurprisefromthegrowthfront.WeexpectmoredetailsoftheseplanstobereleasedattheNationalCongressMeetinginNovember.

Inthelatesteconomicagendarelease,thegovernmenthasagainplacedemphasisonkeyreforminitiativesincludingliberalisingandpromotinginvestmentsinsomeofthestatecontrolledsectorslikefinance,energy,telecomsandrailtransportation;pricingreforminelectricity,naturalgas,andwater;strengtheningsocialsafetynetsandimprovingfoodsafety;andgradualreformoftheurbanhouseholdregistrationsystem.Weseethesereformsaschallengingandneedingstrongpoliticalwill toaccomplish.

WearereducingChina/HongKongtoNeutralinthe3Qaswebelievetherewillnotbeanymajorupsidesurprise inthebroadpicture.The implicationsarethattoplinesalesgrowthandthelackofpricingpowermeansthatASPsarelikelytobeunderpressure.Thesectorsmostaffectedwillbecoal,cement,andmaterials.Sectorswhichareexposedtoexternaldemandarealsounlikelytoseeaturnaroundsoon,exceptthoseexposedtotheUShousingrecovery.

Aneconomicrebalancingisunderwaybutwilltaketime.Majormarketheavyweightsectorlikefinancialsandenergystocksareunlikelytoseesustainablegains.InHongKong,HKDliquidityisaffectedbyanappreciatingRMB.

We continue to believe in the urbanisation theme where IT software, watertreatment, railway transport are sustainable themes in our view. GovernmentsupportfortheSMEsshouldbehelpfulforIThardwareequipmentandcomponent

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manufacturerswhicharenowseeingstrongdemandfromlowcosthandsetsand4Gupgrade.Thebroadmacrotrendoffavourabledemographics,industryconsolidationand upgrades, 4G investments, and increase in productivity, will support thesesectors.

Onbalance,webelievetheHongKongmarketshouldtradeinlinewiththeregion.PossiblecatalystsfortheHongKongmarketwillbedeliveredbyQDII2,andfinancialmarketreformthroughtheliberalisationofinterestandexchangeratesandcapitalaccountconvertibility.WebelievetheHongKongmarkethasalotofvaluewhichwillberealisedwhentherecoverycomesabout.

ASEAN will continue to outperform

ASEAN shines on domestic demand when external demand falters. Investmentthemes for the region have become more prominent driven by several factors.Domestic demand growth, low interest rates, credit expansion, and favourabledemographics(incomegrowth,youngpopulation,largepopulation)arestructuraldrivers.TheslowdowninChina’sgrowthandtheuncertaintyinpoliciestherehavealsodriveninvestorstoseekbetterreturnsinASEANmarketswherepoliciessuchasfiscalspendingaresupportiveofearningsandaremoretransparent.Elsewhere,externaldemandslowdownareaffectingcountrieslikeTaiwanandKorea.Under-investmentanddeleveraginginASEANinthelast15yearshaveledtoconsumptionand investment boom in the region. Liquidity and investability in ASEAN haveimprovedsignificantlyovertheyearsduetostrongdomesticliquidityasaresultofincomegrowth.

Economic growth in ASEAN has been more resilient and less cyclical. We havedowngradedGDPgrowth for China/ Taiwan / Korea/ Singapore but are keepingforecasts for emerging ASEAN countries, and upgraded GDP growth for thePhilippinesdue togrowth surprise.Valuations inASEANarenot cheapat about14xPEonaverage,buttherecentsell-offshouldhavetakensomeheatoffthesemarkets.Growthisstrongrelativetotherestoftheregion.

Key risks for the region are political stability, inflation and capital flows. Thegeneralelectionwas recently concluded inMalaysiaand theremaybeupsideasthe overhang is removed, and foreign investors have under-owned thismarket.Indonesia’selectionnextyearcouldprovidemoresupportforconsumptionstocks.

Whileinflationarypressureisalwayspresentduetolargepopulationandunderlyingstructuraldemandstrength, inflation seems tobeundercontrol in countries likeThailand, Singapore, and the Philippines, which present sweet spots for growthcontinuityinthesecountries.

Overheatingriskspersist,asmarketsaresmallandforeigninflowsarestrongfromtimetotime.Domesticconsumptionboostfromfiscalstimulussuchassubsidiesandraisingminimumincomemaynotjustifysustainableeconomicgrowth.Theneedforreformsandstructuralchangeshoweverpresentopportunitiesinourview.

WeareoverweightinPhilippinesandIndonesia;neutralinThailand,Singapore,andunderweightinMalaysiaamongtheASEANmarkets.

Thailand – pressure points emerging

WearedowngradingThailandtoneutralwithayearendtargetof1500,suggesting11%upsidefromcurrentlevels.Buttherearerisksthatthereboundinthemarketmaynotbe sustainable. Themarket tookabreather inQ2but earningsgrowthsurprisedagainontheupsideinmostQ1corporateresults,promptingustoraiseourearningsgrowthforecastfrom17%to21%(DBSVuniverse).WhileGDPgrowthdroppedfromquartertoquarter,thiscameatnosurpriseafterthesurgeinQ4.TheslowdownintheeconomyalsochangesThailand’soutlookfromhaving“overheat-

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ing”risktoa“slowdown”risk,leavingroomforratecutsin2HthisyearandlesspressureonBOT to curbTHB strength. Thesewill liftmarket sentiments, inourview.

Ourconcernsarethatthemarketmaybeoverdosedwithtoomuchemphasisonthe infrastructure projects to boost growth and thatmarket could snap at onepointiftheoutlookofwhichturns.Thefewpressurepointsareexecution,funding,andcurrentaccountdeficit.

There needs to be sustainablemomentum in the domestic economy and timelyexecutionofthegovernment’sinfrastructureplansinthesecondhalfinordertomaintainour5%GDPgrowthforecastforthisyear.Weacknowledgetheremaybedelaysininfrastructurespendingwhichcouldreducegrowthto4.6%.

Funding for the infrastructure projects, although has been approved by theparliament, still remains unresolved as to whom to borrow the money from.Domestic loan/GDPratio ishighandthe localbankingsystemcouldbe stressed,whileborrowingexternallywould increase risks incapitalaccount,andthus thecurrency.

Domesticconsumptionandprivateinvestmentarestrong.Theinfrastructureplaninisolationisestimatedtoaddanaverageof0.5-1.0pct-pttoheadlineGDPgrowthannually.Howeverwithweakexports,Thailandrunstheriskofbeing incurrentaccountdeficitifdomesticdemandpicksupstronglyabsentarecoveryinexports.

Near term, political risksmay escalatewithmassive demonstrations against thegovernmentifthelatterpusheshardforthereconciliationbill,expectedinAugust.

OurneutralstanceforthemarketisbasedoncheapvaluationsandthatoverheatingpressureinThailandhassubsidedwiththeTHBhavingsoftenedrecentlyandgivingupmostofitsYTDgainswhenfearsmountedonpossiblecapitalcontrolactionsby theBOT. Inflationhasalso stayedbenignat2.4%YoY inApril,despiteassetpriceinflationandanincreaseinminimumwages.ThepotentialimprovementintransportinfrastructureplansinthecomingyearscouldliftThailandtoaneweraasittappedontheresourcesoftheneighbouringcountriesefficiently.

WebelievethatThaimarkethastheabilitytoreboundto1750buttheindexmaynot sustain to the yearendas risks anddisappointments startbuilding.Movingforward,theThaimarketstillhasroomforre-ratingaslongaspoliticalrisksremainundercontrol.

Indonesia

WearemaintaininganoverweightstanceforIndonesia.Weexpecttheindextoconsolidateatcurrentlevelspendingthereviewofthefuelpricesubsidyreform.IfthecurrentproposalbythePresidenttooffsetfuelpricehikeswithothersubsidiesisapproved,themarketshouldseestrongerupsidetowards5,200byyearend.

Strongconsumptiongrowthdrivenbydemographicdividends(youngpopulation,risingincome)willcontinuetosupportthemarket.Theelectionsnextyearcouldalsoboostconsumptionascampaigningwillstartattheendofthisyear.

The higher PE premium should be supported by higher corporate ROEs, whichcanbeachievedbecauseoftheoligopolisticcompetitivestructureinmanyoftheindustriesinIndonesia,suchasbanks,cementandconsumersectors.ThehighROEsshouldbesustainableastheywillonlybeerodedbyrisingcosts,oriftheindustriesareopeneduptocompetition.

What will derail the positive momentum?

IndonesiahadoutperformedtheAsiaandemergingmarketsbenchmarksfor7out

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ofthepast10years.TheJCIhasreturned8%YTDagainsttheregion’s-3%and-6%emergingmarketperformance.

Thekeyriskinthemarketisifglobalappetiteforriskassetsfades.ThiscouldariseifUSbondyieldsspikeupandtriggercapitaloutflowasspreadsnarrowandtherupiahdepreciates.TheMay/Junemarketconsolidationshouldnotbeseenasthebeginningofamarketdowntrend,however.Webelieve it is tooearly forpolicywithdrawalnowastheUS/globalrecoveryisstillfragileandglobalpolicysupportshouldcontinuetodriveriskappetite.

The Indonesia equitymarket correction is driven by the emerging bondmarketselloff triggering currency weakness, and in turn the knee jerk reaction on theequitymarket.Meanwhileweakercurrencyalsomagnifiestheproblemcausedbythefuelsubsidyonthecurrentaccountdeficitposition.BIhasalsoreportedlyusedabigchunkofitsreservestodefendtheweakcurrency,thusweakeningitsexternalbalancepositions.

As a result of the weak global economy, the weak commodity price has beenunfavourable to Indonesia’s external balance. Indonesia’s capital account is lessstablethantheotherAseanmarketsandtherewillbelessroomforBItomaneuvermonetarypolicies,inourview.However,welikethefactthatinflowsinIndonesiaandthusoverheatingrisksarelowerthisyearcomparedtolastyear.

Theoverhanginthemarketrightnowisprobablythefuelpricehikeswhichthegovernmenthasdelayedimplementingsincelastyear.Webelievethemarkethaspartially priced that in and hikes, if announcedwill have limited impact on themarket.

We recommend the infrastructure, property and telco sectors, which are lessdependenton the fuel subsidyoutcome.Banksandconsumers sectorshavenowbecomeattractiveaftertherecentcorrection.

Riskstothemarketisaslowdowningrowthtobelow6%andconsecutiveratehikesifinflationrisesafterthefuelsubsidycut.Wearemaintainingourindextargetat4950pendingtheremovaloftheoverhangonthefuelsubsidyreform.

Malaysia

TherulingpartyBarisanNasional (BN)coalition secured60%ofParliament seatsandthemajorityneededtoformtheGovernmentinthe13thGeneralElectionon5thMay. The benchmark index - Kuala Lumpur Composite Index (KLCI) - shouldtrade on its fundamental merits amid a liquidity boost. Retail participation hasincreasedalongwithreducedpoliticalrisk.ThereisamplelocalliquiditysittingonthesidelinesandMalaysiaremainsunder-ownedbyforeigninvestors,whichspareditfromtheglobalrisksell-offinlateMay.

However,webelievethatMalaysia’svaluationsandlimitedgrowthwillcapitsupside.Earningsgrowthisweak(8%in2013;9%in2014)andvaluationisatapremiumtotheregion(at14.7xearnings;33%premiumtoMSCIAxJ).Malaysiaisvulnerableto external weakness as the economy is export-oriented. Q1 GDP growth datasurprisedonthedownsidewithonly4.1%YoYgrowthagainstconsensusforecastof5.5%.However,thisisattributedtoasurgeinimportgrowthwhileexportgrowthwasrelativelyflat(i.e.netexportsfell).Privateconsumptionhasalsoimproved,butgovernmentspendingandinvestmentgrowthhadtaperedoff,whichisworrying.

Weareupgradingthemarkettoneutral.Thekeyupsiderisktothemarketisforeigninvestors’perceptionthatthemarketcouldchangeandwearegivingthefactorthebenefitofdoubt. ThemarkethasoutperformedYTDdueto itsdefensiveness inthisforeignselloff.Itisabout50%under-ownedbyforeigninvestorsintheAXJbenchmarkedfunds.TheM-reitshaveheldupbetterthantheS-reits.

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TherisksaretheexecutioninETP,andthefiscaldeficit.

Economictransformationprogramme(ETP)couldlosemomentumpost-electionasitisseenasavote-riggingexercise.DBSeconomisthasdowngradedGDPgrowthfrom5.5%to5%asheseesinvestmentgrowthslowingdown.

Malaysiahasahighbudgetdeficit(-4%)duetogovernmentsubsidiesfortollrates,commodities,fuelprice,aswellasinvestmentspendingcommittedfortheETP.Thefundingenvironmentmaychangeifbondyieldskeeprising.

Yieldstocksarealreadyexpensiveaselectionuncertaintyinthelastoneyearhaddriveninvestorstoexpensive(basedonP/E)stocks.ThenextleguphastobederivedfromBanks,O&G,andconstructionandpropertysectors,whicharedependentonthepaceoftheETP,whicharesubjecttoslowdown.

Singapore – a better 2H

Thehigh-yieldinganddefensivenatureoftheSingaporemarketcreatedasharpsell-off in themarketas interest rate risks rose.WebelievetheSTI shouldstagea rebound as soon as there is clarity on the Fed’s stancewithQE, likely at theupcoming FEDmeeting.Webelieve the Fed is unlikely to taper theQE soonasrecoveryisweak.

Theconsolidationisinlinewiththeregionalmarketsselloff.Werealisethatthemarketremainsextremelysensitivetocyclicalshiftininterestratedirection,despitethembeinglow.Astheglobalmacrobackdropislikelytobeswayedbytheinterestrateoutlook,valuationsareunlikelytoexceedaverage.

Earningsgrowthwasweakerthanexpected,leadingtogrowthdowngradesandanunsustainableP/Ere-rating.Unlesstheglobalcyclicalbackdropisstronger,weshouldnotexpecttheexternalcyclicalstodrivegrowth.Thatsaid,Singapore’sGDPshoulddobetter inthe2Hdueto lower inflation,weakerSGD,morestableelectronicsexports,andareboundinpharmaceuticalsproduction.Domesticsentimentshouldremainpositive.

This leavesuswithapositivescenarioof lowinterestrates (albeitwithvolatilityintheexpectations)andamodestgrowthoutlook. Investorsshouldhedgetheiryieldpositionswithgrowth.Pocketsofgrowthareavailableinmid-capswhichareexposedtotheASEANregion,constructionandoil&gassectors.Nichebusinessesarealsofindingsweetspotsinalowinterestrateenvironment,strongliquidity,andwheregrowthiscomingfromaverylowbase.

We are maintaining our year-end STI target at 3450 and believe mid-caps willoutperformthelargecaps.

Philippines

ThePhilippinesmarketvaluationisstretched(>21xFY13PE)butrecordlowbondyields, peso strength, and foreign inflowwill likely keep themarket expensive.Despitethesharpsell-off,themarketisstillthemostexpensiveintheregion,butthatisnotwithoutitsjustifications.1Q13GDPgrowthwasthehighestintheregionat 7.8%YoY, and likely to be sustainable.We have upgraded our GDP growthforecastto6.4%from6%.

Moreimportantly,theeconomyiscurrently inanextendedsweetspotofstronggrowth and low inflation, which offer an opportunity to accelerate overallinvestmentsandgrowth.Interestrateshavefallensharplyoverthepastfewyearsdriven by ample liquidity from capital inflows. The Philippines is still the bestmarketonstrongexternalbalance,butconsequently,thestrongpesomayerodeitscompetitiveness.Thecentralbank(BSP)hasalreadycutthespecialdepositrate(SDA)byacumulative150bpsto2.00%thisyear.AboutPHP2trnofsterilisedmoney

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areparkedwiththeSDA.Unleashingthisliquidityshouldhavefurtherpositiveeffectontherealeconomyasbanksbecomemorewillingandabletoprovideloans.Inthenearterm,wewouldmonitortheprogressonthe22private-public-partnershipprojects (PPP) launched in late 2010. To date, eight projects (total value of PHP106bn)havebeenapprovedandthreecontractshavebeenawarded.

Recentsell-offinthemarketshouldhavetakensomeheatoffthemarket,especiallywithregardtothepeso.WeareraisingPhilippinestooverweightonvaluationandsustainableeconomicgrowthgoingforward.

Korea

TheKOSPI remains range-boundand isnowtradingtowards the lowendof therange.ThemarketdependsheavilyonthefortunesofSamsung(22%oftheindex),forwhichbrokershaveslashedsalesestimatesforS4handsetsduetopoorresponsetoitslaunch.

Onthebroadeconomy,Korea’slatestdatashowedtheeconomyremainedonasoftpatchin2QalthoughgrowthmomentumisnotweakwhencomparedtoTaiwanorChina.Thepositiveeffectsoflowercommoditypriceswereimmediatelyreflectedintheexpansionoftradesurplus,slowdownofinflation,andimprovementinrealhouseholdincomes.CPIinflationdeceleratedto1.0%YoYinMayfrom1.2%inthepreviousmonth,mainlydrivenbythedropinfoodandenergyprices.BankofKoreadelivereditsfirstratecuttoboostgrowth.

WearemaintainingourunderweightstanceforKoreaandexpectthemarkettotraderange-bound.Unlessweseeastrongerglobalrecovery,Korea’svaluationwillbetrappedatthelowerendofitshistoricrange.

Taiwan

TheTaiexhitahighof8400beforesuccumbingtotheglobalsell-offandhaslost3.6%since22May,whichmakes itoneof thebetterperformingmarkets in theregionalsell-off.Thecyclicalfactorsdrivingdomesticdemandarepositive,givenastablelabormarket,slowdownofenergyandfoodinflation,upturninthepropertymarket, and increase in housing construction investment in the private sector.Improving cross-straits relationship has a positive impact on domestic sentiment,inourview.However,consideringtheeconomy’sexportdependentstructure,thedirection of global demandwill remain the key factor thatwill dictate Taiwan’sgrowthoutlookintheshortterm.

WearedowngradingTaiwantounderweight,inlinewithourdowngradeforChinaandtheexternalenvironment.OurindextargetforTaiwanremainsat8500.

India

Following close on the heels of sub-5.0%GDP growth numbers,May’s PMI alsodisappointed.PMI-manufacturingslidto50.1 inMay,downfrom51.0themonthbefore and to a four-year low. The lagged impact of high borrowing costs andthinningdomesticnewordershasbecomemoreevidentinrecentmonths,suggestingthetoughoperatingenvironmentisunlikelytofindanyreprievesoon.

Thefocusfallsbackonthecentralbankandrenewsthedebateontheneedandscale ofmonetary accommodation to boost growth prospects. However, the RBIhasitseyessetonmultiplegoalposts,factoringinexternalimbalances,highretailinflationandpossiblereversalinfiscalconsolidationefforts,alongsidetaperingWPIinflationgauge.Therenewedstreakofrupeedepreciationhashighlightedagainthetwindeficitsandpossibleratingsdowngrade.

WeremainunderweightinIndia.

68

Economics–Markets–StrategyChina

Chris Leung • (852) 3668 5694 • [email protected]

CH

INA

CN: A paradigm shift in macro management

• There is neither fiscal nor monetary stimulus in spite of slower growth

• CNY appreciation quickened even amidst widespread skepticism over the authenticity of trade figures

• Credit is growing at a speed well above real economic growth

• Property prices in most cities continued to charge ahead despite more administration controls

The policies behind China’s recent economic slowdown – including the frugality campaign and ongoing tightening measures imposed on the property market – have worked exceedingly well. Real GDP decelerated to a four-year low of 7.7% in 1Q13. Yet, the labor market has remained generally tight. Widespread reports of unemployment are absent. Inflation, as measured by the CPI, has come down to around 2%. On such counts, there should be nothing to worry about. The authorities have done a fair job in engineering a soft landing.

However, the monetary side of the economy tells another story. M2 advanced rapidly to 15.8% YoY in May which exceeded the 13% annual target and nominal GDP growth of 9.6% in 1Q13 (Chart 1). This could well be a result of the trade surplus ballooning to USD 43bn in 1Q13 from only USD 210mn in 1Q12. Some people argued that the trade surplus was inflated due to over-invoicing of exports to bring in money illegally given ongoing appreciation of the CNY. Whatever the case, the mirror image of rapid money supply is faster credit growth. Loans in the first five months of this year surged 14.5% YoY. Under normal circumstances, rapid credit growth usually predates a rebound in asset markets. But the performance of the A share market has been disappointing (Chart 2) and ever tighter administrative measures on the property market do not seem to suggest money is pouring heavily into that sector either.

One peculiar observation from the breakdown of total social financing is the explosive growth of trust loans and entrusted loans eclipsing conventional bank loans. This phenomenon reflects: (1) companies are looking for higher yields as deposit rates in real terms have been artificially depressed for years; (2) companies in need of credit are unable to obtain them from conventional borrowing channels. Without quickening the pace of interest rate liberalization, rapid growth of off-balance sheet financing will continue. The potential risks rendered by the sizzling growth of these loans cannot be underestimated.

The current state of the macro-economy suggests real economic activities will pick up slowly. Part of this feebleness is likely to be caused by small-to-medium sized enterprises burdened by heavy borrowing costs. In a slowing economy, the challenges to survival are daunting. There is no easy fix to the problem. Cutting interest rates to reduce borrowing costs, as some people are speculating, will only reinforce the root cause of the problem. That’s because lower rates make chasing higher yields justifiable. Besides, lowering of benchmark rates may not necessarily translate into lower funding costs for the final borrowers. Lets’ also not forget the property market is still blistering. The dominant strategy is to keep the status quo

Real economic activities will pick up slowly

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on monetary policy, and quicken interest rate liberalization so that banks have more freedom to determine deposit and lending rates. This is the most challenging part and requires careful planning given the numerous stakeholders involved. Hopefully, interest rate reform will gather pace in 2H13. We continue to envision an upward bias in domestic interest rates once reforms kick in.

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Chart 3: Change in position for forex purchase

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The roaring CNY

The steady appreciation in the CNY this year, in spite of slower growth and the absence of imported inflation, has puzzled many. The spot CNY has appreciated 1.5% YTD against the USD, by over 20% against the JPY, and even more in trade-weighted terms. This was in spite of the narrowing in the current account surplus to only 2.4% of GDP in 2012 from over 10% in 2007. Then, there is also skepticism over the authenticity of trade figures due to export over-invoicing. The softer PMI in May did not halt the appreciation. The market rate consistently traded at the strong side of the official trading band.

Some believed that the CNY was allowed to appreciate to facilitate the US-China Annenberg summit. There were numerous similar diplomatic experiences since July 2005. The bottomline is that Beijing is willing to let the currency strengthen to better reflect market forces, which is consistent with the large increase in position for forex purchases in the first five months of this year (Chart 3).

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Economics–Markets–StrategyChina

The corresponding 15.8% surge in during May, which exceeded the 13% annual target, also suggested persistent capital inflows into China. If that is the case, the disconnection between the CNY exchange rate and real economic performance could last for quite a while. The CNY will likely trend up for the rest of the year notwithstanding transient dips.

The recent exchange rate management style is a major departure from past practices. Authorities, nowadays, have demonstrated more willingness to allow exchange rate fluctuations to reflect with market forces even though it complicates the management of domestic monetary policy. The new approach warrants tighter monetary policy, especially when property prices are still charging up (Chart 4). Inflation, as measured by the CPI, will probably trend upward again in 2H13.

Contrasting policy objectives

The co-existence of elevated asset prices and slower economic growth will prevail as long as quantitative easing floods the world with liquidity. Striking a balance between two contrasting policy objectives requires in-depth diagnostics within appropriate contexts. At this juncture, China has clearly chosen to accept “normal” growth relative to “supernormal” growth prior to 2008.

In retrospect, China would have much more policy flexibility now if it had allowed its exchange rate to appreciate more and interest rate reform to quicken more when the economy was stronger a few years ago. It is better late than never to resolve problems.

The solutions are clear: (1) Maintain a stronger currency; (2) Carry on with interest rate reform; and (3) Map out a clear urbanization strategy to stimulate domestic demand. Point 1 is progressing well; Point 2 has stalled for some time and details of Point 3 remain sketchy.

In the absence of monetary loosening and fiscal stimulus alongside a strengthening exchange rate, the strength of subsequent recovery will likely to be tepid. The economy will most likely be “hanging in there” without too much upward surprises. In fact, slower economic growth is natural during a transitional period.

As such, we have revised our full-year GDP forecast downward to 8.0% from 8.5% previously. This revision should not be read too negatively because China can easily propel growth by relaxing restrictions in the property market, or by simply following in the footsteps of other central banks to conduct quantitative easing. Yet the authorities have chosen to walk a difficult path of structural reforms. This is definitely the right path to tread and is an encouraging development.

The recent style of exchange rate management is new

China has chosen normal growth over supernormal growth

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Chart 4: Average residential property price growth

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China Economic Indicators

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Real GDP growth 7.8 8.0 8.5 7.7 7.9 8.0 8.2 8.5 8.5GDP by expenditure: current price

Private consumption 11.5 13.5 15.0 13.5 13.5 13.5 13.5 15.0 15.0Government consumption 12.8 15.0 16.0 15.0 15.0 15.0 15.0 16.0 16.0Urban FAI growth (ytd) 20.6 21.0 22.0 20.9 21.0 21.0 21.0 22.0 22.0

Retail sales - consumer goods 14.3 13.5 14.0 12.6 13.5 13.5 13.5 14.0 14.0

ExternalExports (USD bn) 2,049 2,300 2,645 509 597 590 604 585 687

- % YoY 8 12 15 18 14 9 9 15 15Imports (USD bn) 1,818 2,010 2,311 466 513 512 517 536 589- % YoY 4 11 15 8 13 11 10 15 15

Trade balance (USD bn) 230 290 333 43 85 78 86 49 98Current account balance (USD bn) 193 281 323 n.a. n.a. n.a. n.a. n.a. n.a.% of GDP 2.3 2.9 2.9 n.a. n.a. n.a. n.a. n.a. n.a.

Foreign reserves (USD bn, eop) 3,375 3,773 4,225 n.a. n.a. n.a. n.a. n.a. n.a.FDI inflow (USD bn, YTD) 112 117 129 30 60 90 117 33 66

Inflation & moneyCPI inflation 2.7 3.5 3.5 2.4 2.8 4.0 4.6 3.5 3.5RPI inflation 2.0 1.7 1.7 1.4 1.3 1.9 2.2 1.6 1.6

M1 growth 6.5 10.9 10.6 11.8 12.1 11.3 10.9 10.5 10.5M2 growth 13.8 14.5 14.0 15.7 16.0 15.0 14.5 14.0 14.0

OtherNominal GDP (USD bn) 8,376 9,708 11,192 n.a. n.a. n.a. n.a. n.a. n.a.Fiscal balance (% of GDP) -1.8 -1.5 -2.0 n.a. n.a. n.a. n.a. n.a. n.a.

* % change, year-on-year, unless otherwise specified

72

Economics–Markets–StrategyHong Kong

Chris Leung • (852) 3668 5694 • [email protected]

HO

NG

KO

NG

HK: More inflation

Property prices are creeping up again

Property prices were 2.8% below their peaks in mid-March due to government intervention. Yet, a drastic correction of more than 10% is unlikely this year. In fact, prices have been creeping up again beginning mid-May. The most fundamental reason is the demand-supply imbalance. One can infer from the quick price ascent in recent years that the imbalance was quite huge. Even discounting investment demand, pent-up demand from end-users is enormous. Demographically, higher birth and marriage rates in recent years have increased the demand for space.

Furthermore, the holding power of existing home-owners is strong amid ultra-low interest rates. Owner-occupiers, in particular, are unlikely to sell their properties in response to recent government clampdowns because it is costly to rent or to purchase an alternative property due to increased stamp duties. As such, an unintended consequence of government intervention is the further squeeze in the the supply of secondary market properties. Residential property transactions have already dropped by 32.1% YTD.

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• Hong Kong slipped to third place from first place in a global competitiveness ranking, and came third-last in the category of “prices”

• Property prices are creeping up again since mid-May after a small correction from the peak in mid-March

• Residential rents held up even as property prices corrected; meanwhile, commercial rentals are still charging up

• Retail sales have clearly made a comeback since bottoming-out in 3Q12. Slower economic growth in China did not make a lasting dent in tourist spending in Hong Kong

Residential prop-erty prices are creeping up again beginning mid-May

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Inflation impacted competitiveness

Protracted periods of high inflation have affected Hong Kong’s competitiveness. Hong Kong slipped to third place from first place gained in 2011 and 2012 in a global competitiveness ranking, compiled by the Swiss-based International Institute for Management Development. Although Hong Kong is still the best achiever in business legislation, international trade and technology infrastructure, it ranked third-last for the category of “prices”, ranked 57th (out of 60) for cost-of-living index, 58th for office rent and 59th for apartment rent.

Rental inflation is a nagging problem. Private residential rents fell very mildly (HK$22.8/sqft in April versus $22.9/sqft in March, 0.4% drop) after rising for 12 months straight, but are still up 16.9% YoY. Historically, rental growth tracked property prices very closely (Chart 1). However, it may turn out to be different this time, as government clampdowns on the property market have inadvertently stirred interest in the rental market.

Commercial rents (shopping centers and alike) continue to inflate quickly; the extra costs have been passed on to consumers. After the Individual Visits Scheme was introduced in July 2003, retail sales volumes grew 8.6% on average per year since 2004. The stock of commercial space, however, only rose 2.0% on average in the same period. Discrepancies between the growth of retail sales and retail space helped explain the surge of retail rents in recent years (Chart 2).

Going forward, retail space expansion will slow. Space is estimated to increase only 5.4 million sq ft over from 2012 to 2016, compared to 6.2 million sq ft over 2007-2011, according to Jones Lang LaSalle. Retail sales volume, on the other hand, will grow steadily on the back of tourist spending and a resilient local labor market. Such shortage of retail space has prompted retailers to mark-up prices or sell more expensive products, as Chart 3 shows. Upward revision in the minimum wage to $30 per hour from $28 effective from May 1 will add exacerbate cost push inflationary pressure in the months ahead. Inflation on a wide variety of goods and services will likely remain sticky for a while.

Tourist spending to outperform locals’ spending

Retail sales have clearly made a comeback since bottoming-out in 3Q12. Year-to-date, retail sales values are up 15.5%, much higher than 7.6% in 4Q12. Slower economic growth in China did not make a lasting dent in tourist spending in Hong Kong. Growth in tourists’ retail spending (using a proxy derived from popular tourist items) has leaped to 44.2% in April versus 6.2% in March even as the growth of mainland tourist arrivals rebounded to just 17.5%, versus 13.8% in March. In

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There is a serious shortage of retail space

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particular, the growth in the sales of jewellery, watches and valuable gifts were up 68.4% in April versus 11.2% in March. The sudden plunge in gold prices in mid-April explains much of the strength in jewellery purchases, but tourists must be willing and able to spend in the first place.

In theory, the mainland’s frugality campaign should negatively impact Hong Kong’s luxury retail market. But for now, the numbers tell a different story, suggesting tourists’ propensity to consume has remained strong. It is also possible that some luxury spending has shifted from more conspicuous items to low-key items. Strong tourist spending will continue to lend support to Hong Kong’s retail sales this year.

Meanwhile, the growth in locals’ spending will probably ease slightly. As Charts 4 & 5 show, locals’ spending tracked the Hang Seng Index and the property price index well, and both these measures have retreated somewhat. In 2013, retail sales values and volumes are projected to grow at least 15% and 12% respectively (2012: 9.8% and 7.2%).

Consumption to jumpstart recovery again

Against a backdrop of upbeat retail sales, consumption is expected to lead Hong Kong’s economic recovery once again. Private consumption (of residents) has leaped 7.0% in 1Q13 from 2.8% in 4Q12. As private consumption accounts for about 65% of GDP, its acceleration explains higher GDP growth forecast this year (4.0%), versus just 1.5% last year.

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Chart 5: Locals' retail spending versus property prices

Tourists’ propensi-ty to consume has remained strong

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Nevertheless, weakness in merchandise trade prevails. For the first four months of the year, merchandise exports and imports are up 5.2% and 5.6% respectively (versus 3.9% and 4.9% in 4Q12). Despite slight improvement in growth rates, the merchandise trade deficit has widened to HK$153bn from $141bn in the same period last year, thereby dragging down growth.

Geographically, exports to Europe, the US and Japan continue to disappoint with negative growth rates year-to-date of -3.5%, -2.1% and -4.0% respectively. As roughly one-quarter of Hong Kong’s exports goes to the G3, considerable recovery in merchandise trade is unlikely in 3Q. That said, the pickup in Asian demand (exports up 7.3% YTD) – which accounts for over 70% of exports – is expected to cushion the sluggish growth of Western economies.

No surprises

The storyline is similar to 2Q’s – private consumption will spur growth; labor markets will remain stable; external trade will be fragile and inflationary pressures will stay. Growth will be better than before but below trend. The biggest economic risk – an imminent bubble burst in Hong Kong – is somewhat mitigated for the time being due to administrative controls. The short term volatility of property prices observed hitherto in either direction has been in a controlled manner, and the risk of sudden US interest rate hikes is low.

Note: Hong Kong’s real GDP growth rates are expressed in terms of 2011 prices

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Hong Kong Economic Indicators

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2012 2013f 2014f 1Q13f 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandGDP growth (11P) 1.5 4.0 4.0 2.8 4.5 4.5 4.1 4.1 5.1

Private consumption 3.2 5.8 4.5 7.0 5.5 5.8 4.9 4.5 4.5Government consumption 3.7 2.5 3.0 2.0 2.0 3.0 3.0 3.0 3.0Investment (GDFCF) 9.4 0.7 4.4 -2.2 -2.5 3.5 3.5 4.4 4.4

Exports of goods and services 1.8 9.2 7.1 7.9 9.3 9.9 9.6 7.1 7.1Imports of goods and services 2.8 9.5 6.9 8.7 8.5 10.8 9.8 6.9 6.9

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External (nominal)Merch exports (USD bn) 443 474 515 105 115 127 127 113 127

- % YoY 3 7 9 4 7 10 8 8 10Merch imports (USD bn) 531 532 629 119 131 141 141 128 145

- % YoY 4 5 10 5 6 8 5 8 11Trade balance^ (USD bn) -88 -57 -114 -14 -15 -14 -14 -15 -18

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Inflation CPI inflation 4.1 4.5 3.5 3.7 4.3 4.9 5.0 3.5 3.5

OtherNominal GDP (USD bn) 263 280 298 - - - - - -Unemployment rate (%, sa, eop) 3.3 3.3 3.3 3.5 3.5 3.3 3.3 3.3 3.3

* % change, year-on-year, unless otherwise specified^ Balance on goods

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78

Economics–Markets–StrategyTaiwan

Ma Tieying • (65) 6878 2408 • [email protected]

TAIW

AN

TW: Recovery is delayed

• We forecast modest growth of 2.6% this year, and expect a fuller recov-ery to 4.0% only in 2014

• Fiscal policy tightening will be postponed

• The progress of reforms / deregulations will likely pick up

• The possibility of monetary policy easing is relatively low

GDP growth slowed to 1.7% YoY in 1Q13 from 4.0% in 4Q12. Quarter-on-quarter growth contracted by -2.8% (saar), down from 7.1%. Economic activity should remain subdued in 2Q, given the weakness in key indicators including exports and industrial production in Apr-May.

In light of the poorer-than-expected 1H performance, the government in May cut the annual GDP growth forecast to 2.40%, sharply lower than the previous estimate of 3.59%. We now also forecast modest growth of 2.6% this year, and expect a fuller recovery to 4% only in 2014.

Exports outlook is challenging

The outlook for exports is challenging. The market exposure of Taiwanese exports is tilted towards the G3 and China (a combined share of 70%). Europe has slipped into recession, due to budget deficit reductions and public sector deleveragings. Fiscal spending cuts have just begun in the US, and the private sector recovery remains fragile. On the other hand, China’s new administration focuses on long-term structural reforms and is in no hurry to boost the country’s short-term growth momentum. Against such a backdrop, chances are increasing that a significant

Exports are tilted towards the G3 and China markets

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TaiwanEconomics–Markets–Strategy

recovery in Taiwan’s exports will be delayed. Export orders fell notably in 1Q and rebounded only slightly in April. There are no clear signs of an export recovery in the next 1-3 months (Chart 1).

From the technical perspective, we still expect net exports to lift GDP growth in 2H13. Net exports cut quarter-on-quarter (saar) GDP growth by -7.7ppt in 1Q. This was because gross capital formation jumped strongly by 26.5% QoQ saar, and the surge in investment boosted import demand for capital goods. Real import growth outpaced real export growth for the first time over ten quarters in 1Q (Chart 2).

On an annual basis, the contribution of net exports to GDP growth was consistently positive over the past decade, except in 2004 when gross capital formation rose near 20% driven by the construction projects of high-speed railways (Chart 3). Without a repeat of large-scale infrastructure investment this year, a 20% investment expansion should be unlikely. Accordingly, net exports should maintain positive growth this year. We expect net exports to normalize from 2Q onwards.

Fiscal policy tightening will be postponed

On the policy front, in order to bolster growth, the government’s fiscal policy tightening will likely be postponed. Last year the government cut energy subsidies (raised fuel and electricity prices) and legislated capital gains tax in an attempt to reduce fiscal deficits and improve income distribution. Under the capital gains tax plan, individual stock market investors will need to pay tax rates of 0.02-0.06% on the selling prices of shares from this year, once the TAIEX rises above the 8,500 level. In light of the weaker-than-expected economic performance so far this year, the government in May proposed to revise the tax bill and exempt individual investors from paying the tax. The revised bill has been submitted to the parliament in end-May. If approved, it should help public sentiment in the near term.

Under the energy price reform plan, the second-stage electricity price hike (10%) is slated in October this year. We think the government has sufficient leeway to postpone the price hike, if economic conditions don’t improve strongly in 2H13. After all, fiscal balance has already improved thanks to last year’s reforms. Despite weak economic growth and weak tax revenues in 2012, the fiscal deficit-to-GDP ratio fell to 1.6%, compared to 1.8% in 2011 and 3% in 2009-2010. As the public debt ratio remains lower than the legal limit of 40% (about 36% in 2012) and most

Capital gains tax bill will be revised

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of the debt is financed domestically, there should be no urgency for the government to push for aggressive fiscal consolidation.

Even if the electricity price hike takes effects as scheduled, it shouldn’t have a great impact on inflation and consumption. The hike will be concentrated on big electricity spenders (the wealthier households). The majority of households (67%) won’t be affected, according to government estimates. In fact, overall inflation pressures are currently easing fast thanks to the recent correction in global oil prices. Consumer confidence has also rebounded. We expect consumption growth to pick up in 2H13 on the back of lower inflation and stronger confidence (Chart 4).

Progress of reforms / deregulations likely to pick up

While we think fiscal policy tightening will be postponed, we don’t think there is much scope for the government to loosen fiscal policy and arrange new stimulus measures (unless the public debt law is revised and the debt ceiling is lifted). Alternatively, the government is likely to focus on reforms / deregulations to boost sentiment and revive the economy.

The progress of cross-strait trade and investment liberalization is expected to reaccelerate after China’s leadership transition. It was reported that the Chinese and Taiwanese authorities have already completed negotiations on cross-strait service trade under the Economic Cooperation Framework Agreement. The service trade pact will be signed at the 9th cross-strait talk in June/July.

China will offer Taiwan preferential treatment in terms of access to 65 services segments (better than that under the WTO commitments). This will provide opportunities for Taiwanese companies to expand and penetrate into China’s services market, where rising per capita incomes has led to increasing demand and an upgrading of consumption structure.

Meanwhile, more policy initiatives to foster Taiwan’s offshore renminbi market may be on the way. Since the RMB businesses started in Taiwan’s banking sector in February this year, RMB deposits in domestic banking units (DBUs) have increased strongly to reach CNY 30bn within three months (Chart 5). The retail RMB deposit rates offered by local banks are high at 1-2% (1 year), comparable to the TWD deposit rate of 1.36%. The attractive yields coupled with the strong expectations of renminbi appreciation in the past few months should have encouraged Taiwanese individual investors to hold the RMB assets.

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For now, the proportion of Taiwanese corporates using renminbi as the trade settlement currency remains low. The size of RMB cross-border trade settlement amongst DBUs stood at only CNY 0.7bn in March. Even including the offshore banking units, RMB trade settlement amounted to only CNY 9.3bn in March, equivalent to 11% of Taiwan’s total bilateral trade with China and Hong Kong (USD 13bn per month). Micro-level deregulations can be made to encourage the use of renminbi in cross-strait trade transactions, such as simplifying the documentation required for RMB trade settlement. To boost the incentives for Taiwanese companies to receive and accept renminbi, establishing the RMB circulation/investment channels (such as RMB-FDI) will also be crucial. Negotiations with China about the RFDI and RQFII quotas should be on the policy agenda this year.

Don’t expect monetary policy easing

Reforms / deregulations bode well for economic prospects in the long run. In the short term, the growth outlook still largely hinges on the global business cycle. If the global recovery is delayed and domestic growth stays weak for an extended period, the call for monetary policy easing could increase.

Last year, rate cut expectations intensified in July, when the Greek debt crisis worsened, the global economy deteriorated and some Asian central banks cut rates in response. But Taiwan’s central bank (CBC) didn’t follow suit as inflation was high at 2% last summer on the back of energy price hikes.

Now inflation has fallen notably to 0.9% YoY (Apr-May on average). Does it mean the door is open for a rate reduction? We don’t think so. Monetary policy is already very accommodative and interest rates are extremely low. The overnight interbank rate currently stands at only 0.39%, and the inflation-adjusted short-term real interest rates remain negative (Chart 6). The scope for cutting rates is constrained.

Meanwhile, asset price inflation remains strong and it is still a concern for the central bank. The CBC attempted to cool property prices in 2010-2012 via several rounds of credit rules tightening, including lowering the loan-to-value ratio on mortgage loans in specific areas (Taipei and its vicinity), and on loans for high-value property purchases. Nevertheless, property prices have continued to rise strongly, and the rise has spread from Taipei to broader areas of the island (Chart 7). Lower interest rates could further fuel asset prices and the central bank has to be wary of such side effects of monetary easing. We maintain the forecast that the benchmark discount rate will stay on hold at 1.875% for the rest of this year.

Asset price infla-tion remains a concern

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Taiwan Economic Indicators

2012 2013f 2014f 1Q13f 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandGDP growth 1.3 2.6 4.2 1.7 2.4 3.0 3.1 4.1 4.8Private consumption 1.5 1.1 2.4 0.3 0.8 1.5 1.6 2.2 2.5Government consumption 0.5 0.7 0.7 0.4 0.1 1.1 1.2 0.6 0.8Gross fixed capital formation -4.2 4.3 3.0 7.4 2.6 3.0 4.6 -1.5 3.9

Net exports (TWDbn, 06P) 2911 3074 3428 636 742 789 907 747 819 Exports (% YoY) 0.1 4.0 6.0 4.8 4.3 3.3 3.7 4.7 6.3 Imports (% YoY) -2.1 3.4 4.0 6.6 2.2 1.5 3.6 0.7 4.9

External (nominal)Merch exports (USDbn) 301 311 337 73 76 79 82 79 86- % chg -2.3 3.1 8.6 2.4 0.2 3.2 6.4 8.9 12.3Merch imports (USDbn) 270 275 304 68 66 69 72 72 78- % chg -3.9 1.8 10.6 4.4 -6.2 1.2 8.3 6.0 18.8

Trade balance (USD bn) 31 35 33 5 10 10 10 7 7Current account balance (USD bn) 50 54 53 - - - - - -% of GDP 10.5 11.1 10.2 - - - - - -


InflationCPI inflation 1.9 1.0 1.3 1.8 0.8 0.3 1.0 0.9 1.5

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Economics–Markets–StrategyKorea


KO

REA

KR: Not too weak

• Despite weak sentiment, economic growth in Korea is not too weak and it outperforms peers

• Export competitiveness remains intact

• Fiscal, monetary and property market policies are all supportive

• We forecast 2.8% growth this year, higher than 2.6% in Taiwan and 2.5% in Singapore

Market sentiment has been weak through the first half of this year, against the backdrop of Japanese yen depreciation, China slowdown, North Korea tensions and more recently, growing worries over the US’s withdrawal of QE. As far as the real economy is concerned, the performance is not so weak. Real GDP growth accelerated to 3.4% QoQ saar in 1Q13 from 1.1% in 4Q12, not too far from the long-term average of 4.0%. This was also in contrast to the sharp growth slowdown seen in regional peers including Taiwan and Singapore in 1Q.

For the full-year of 2013, we expect Korea to achieve an annual growth rate of 2.8%, outperforming Taiwan (2.6%) and Singapore (2.5%). Our forecast also stands higher than the official projections made by the Bank of Korea (2.6%) and the Ministry of Strategy and Finance (2.3%).

Exports shouldn’t be too weak

While global trade demand has been subdued so far this year and the Japanese yen has depreciated sharply, Korean exports still fared relatively well. The year-on-year export growth (in USD terms) stayed slightly positive during the first five months of 2013, in contrast to the contraction in Japanese exports (also in USD terms, Chart 1). Notably, Korea’s electronics exports maintained double digit growth of over 10%

The official growth forecasts are achievable

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YoY so far this year, while Japan’s electronics exports continued to fall sharply by more than -10% YoY (Chart 2).

The weakening of the yen is not a big risk to Korean exports, in our view. The non-price core competitiveness of Korean exports is strong, stemming from the enhancement of technology, establishment of brand names and diversification of market exposure. Competitiveness is particularly evident in the electronics industry. Korean electronics firms upgraded technology and captured the global wave of smartphone and tablet products in recent years, while Japanese firms struggled to keep up. A price cut of the Japanese brand PCs and handphones doesn’t mean a direct threat to Korea, as the latter concentrates on smartphones and tablets.

The main risk to Korean exports is a delayed recovery in global demand. That said, under the scenario of prolonged weakness in external demand, we think the overall Korean economy will still fare better than the smaller and more open economies in the region. Goods exports accounted for 47% of Korean GDP in 2012, not too high compared to the ratios of 64% in Taiwan and more than 100% in Singapore.

Domestic policies are supportive to growth

In the domestic economy, fiscal, monetary and property market policies are all supportive of growth. The Bank of Korea lowered the benchmark rate by 25bps to 2.50% in May, the first cut since Oct12. Meanwhile, the finance ministry announced a supplementary budget worth KRW 17.3trn in April (already approved by the parliament in May). Fresh spending in the extra budget is estimated at KRW 7.3trn, which is expected to boost GDP growth by a total of 0.6ppt and most of its impact will be felt in the economy in 2H13.

Specifically, KRW 3.0trn will be spent to boost consumption, through creating jobs and stabilizing consumer prices. We believe private consumption growth will rebound in the coming quarters after a temporary pullback in 1Q, when durable goods sales (automobiles and electronics) reacted excessively to the expiration of consumption tax cuts (Chart 3).

Meanwhile, the government’s relaxation of property market rules should revive housing consumption in 2H13. Property transactions and prices were sluggish in recent years, mainly due to the government’s tight controls on household loans. That said, a temporary rebound in property transactions was witnessed during several episodes since 2010, thanks to temporary tax breaks (Chart 4). This includes

Consumption growth likely to rebound in 2H

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Chart 3: Durable goods sales fell temporarily due to expiration of stimulus

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Chart 4: Property transactions rebounded

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the periods of Mar11-Dec11 and Sep12-Dec12, when the government cut real estate acquisition tax by 50%.

This time, between Apr13-Dec13, the real estate acquisition tax will be fully exempted for first-time home buyers earning less than KRW 60mn per year and buying properties worth less than KRW 600mn. There will also be a five-year capital gains tax exemption on properties valued at less than KRW 900mn. Based on the past experiences, property transactions can rebound quickly and the rebound will last through the rest of this year.

After all, the potential housing demand remains strong in Korea and there is still a large pool of prospective home buyers. Although housing transactions and prices were subdued in recent years, housing rentals rose very strongly (Chart 5). As a result of rising rentals, property prices valuation in fact has become more attractive.

Don’t expect further rate cuts

The Bank of Korea’s rate cut in May was intended to “maximize the effects of the government’s supplementary budget”, as said by the governor. It doesn’t seem the central bank is preparing to ease monetary policy further in the near term. The BOK projects GDP growth to rise to 4.0% (QoQ saar) in 2H13, back to the long-term potential growth rate that is estimated at 3.3%-3.8%. The BOK governor also said in May that annual growth forecasts could be lifted by 0.2ppt for 2013-2014, based on the fiscal and monetary stimulus measures rolled out recently. Unless the 2H global outlook deteriorates and the recent easing becomes insufficient to deal with the slowdown risks, there would be little reason for the BOK to cut rates further. We expect the benchmark rate to stay unchanged at 2.50% for the rest of this year.

The KRW weakened versus the USD in 1H this year, initially due to the currency war worries triggered by JPY depreciation, and more recently, due to the fall in global risk appetite as a result of concerns over the Fed’s QE tapering. On the fundamental front, we note that the support to KRW remains intact. The current account surplus has widened to USD 5.0bn (sa) in Jan-Apr13, compared to the monthly average of USD 3.6bn in 2012. Gross external assets have climbed to an all-time high of USD 544.5bn as of 1Q13, and the external debt coverage ratios have improved substantially over the past several years (Chart 6). The strong current account balance and strong international asset positions should help to contain the KRW’s volatility, in the event of global risk aversions and foreign capital outflows.

Policy rate to stay at 2.50% in 2H

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Korea Economic Indicators

2012 2013f 2014f 1Q13 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandGDP (05P) 2.0 2.8 4.0 1.5 2.2 3.2 4.1 4.2 4.1Private consumption 1.7 1.9 3.1 1.5 2.1 2.1 2.1 3.3 3.0Government consumption 3.9 3.3 3.4 1.3 2.9 4.0 4.9 4.3 3.6Gross fixed capital formation -1.7 2.3 2.9 -3.8 1.6 3.0 7.2 4.2 3.0

Net exports (KRW trn) 104 115 132 22 29 30 34 26 33 Exports 4.2 5.4 8.0 3.4 4.8 4.9 8.2 7.2 8.2 Imports 2.5 4.3 6.3 1.8 4.4 4.1 6.7 5.7 6.6

External (nominal)Merch exports (USD bn) 548 576 639 135 143 145 152 146 165- % YoY -1.3 5.0 11.1 0.4 2.2 9.0 8.6 7.9 15.0Merch imports (USD bn) 520 535 606 130 129 134 142 145 152- % YoY -0.9 3.0 13.2 -2.9 -1.1 6.7 9.7 11.7 17.8

Trade balance (USD bn) 28 40 33 6 14 11 9 1 13Current account balance (USD bn) 43 44 37 - - - - - -% of GDP 3.8 3.6 2.7 - - - - - -



OtherNominal GDP (USD bn) 1,131 1,210 1,354 - - - - - -Unemployment rate (eop %, sa) 3.0 3.1 3.0 3.2 3.1 3.1 3.1 3.2 3.1Fiscal balance (% of GDP) -1.4 -1.6 -0.5 - - - - - -


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Economics–Markets–StrategyIndia

Radhika Rao • (65) 6878 5282 • [email protected]

IND

IA

IN: Stuck in negative loop

Floor in sight, but return to high growth distant …

The broad deceleration in GDP growth is still the key source of concern for the economy. From average 9.0% in FY09/10-11, growth slowed to 5.0% in FY12/13. Was that the trough? Few early signs suggest it was, but the upswing from here will be painstakingly slow as the sectors/ engines that have lost steam are difficult to revive, especially in a pre-election year. Our estimates are for FY13/14 GDP growth to inch up to 5.7% YoY followed by a gradual grind to 6.1% the year after.

On the pertinent question of which leg will provide that much-needed support - the answer lies in this being a pre-election year. As Chart 1 highlights, growth in government spending in previous pre-/election years has been higher than the non-election averages. This imparts the much required fiscal stimuli and this time is unlikely to be any different. In fact the Union Budget already carries the signage. Plans are to undertake a 16% increase in total expenditure, with a 29% rise in plan and 10% in non-plan expenditure. The allotments to the rural welfare programs were upped by nearly a half, laying the ground for a more accommodative fiscal stance (details dealt with in the ‘no free lunch’ sub-section).

Apart from step-up in government spending, stabilisation in consumption expenditure should also provide some support on the back of gradual transmission of rate cuts, slowing inflation and accommodative fiscal stance. The growth of

• GDP growth likely hit bottom, but recovery to be painstakingly slow as the sectors/ engines that have lost steam are difficult to revive, especially in a pre-election year

• Risks of renewed fiscal strain cannot be ignored; bears close scrutiny; FY13/14 fiscal targets to be missed

• Risks of a move to sub-investment rating are likely to resurface late-2013- early 2014 as pre-election spending is ramped up and political worries heighten

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Deja-vu??

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IndiaEconomics–Markets–Strategy

this component halved from 5.5% in FY10/11 to 2.5% in FY12/13 burdened by high inflation and high borrowing costs. There should be some relief to 3.5% in FY13/14, though not dramatic given the limited scope of rate cuts here on.

Capex spending, from the private sector in particular, is likely to remain weak ahead of the elections and little room for the government to push forward with big-bang reforms. We are sceptical on the passage of the land acquisition bill and FDI in select key sectors in the upcoming parliamentary sessions. Today’s investment is tomorrow’s productive capacity and with limited scope of a revival here, one can expect this component to pullback further. The gross domestic capital formation could fall back from 38.4% of GDP in FY09/10 to 34% in FY13/14 (see Chart 2).

Improvement in few indicators have added to the case that a floor is possibly in sight. Activity in a handful of sectors were off their trough in 4Q12 (Jan-Mar13). The money supply indicators, especially the M1 measure has got off its back to rise 8% in the last four quarters. Easing inflation and weak commodity prices have also helped anchor inflationary expectations, which is positive for consumption trends. The Cabinet Committee of Investments established by the government has also successfully approved some stalled projects, primarily in the oil and gas sectors. But compared to the scale of pending projects, the value of approvals still falls short at less than 10% of the total. In sum, while GDP growth should look up, a return to above 7% at least in another two years holds a very low probability, in light of the tight monetary policy and difficulty in setting right the structural constraints.

… but no free lunch!

The ability to not only meet but undershoot the FY12/13 fiscal deficit target at 4.9% of GDP was a commendable achievement, especially as street estimates were for a jump of a magnitude of 50-100bps above target (at 5.2%). However, odds for a deja-vu this year are limited and initial signs are already evident in the Apr13 data. While we acknowledge that a point does not make a trend, nonetheless this is an area worth watching closely and validates our view that revival in fiscal expenditure will be the main source of support for growth this year.

A close look at the FY12/13 expenditure trends, especially 2H, when fiscal consolidation efforts struck a high note, show that while the non-Plan (which includes defence, subsidies, interest payments etc) allotments were at 99.7% of budgeted estimates, the plan spending was at 80%. This signals that much of the ‘expenditure rationalisation’ stemmed from a cutback in the plan component, which usually contributes materially to growth.

Capex revival likely to be delayed further

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Into FY13/14 and the differential treatment of plan and non-plan expenditure persists. We compare data available for Apr13. Again, aware that this is only the first month, the non-plan expenditure jumped 15.4% MoM seasonally adjusted (vs average +1.2% in Oct12-Mar13). The nominal allocations were the highest since Jun12. This compares with the -7.7% MoM, sa (vs average +2.4% in Oct12-Mar13) in the productive plan expenditure (see chart - left below).

Total government receipts fell 55% MoM in Apr13, rising compared to year ago collections. However, we will not over-read this sub-section given the highly seasonal nature of tax collections. Recent Finance Minister’s comments that also reiterated that expenditure plans will remain on track, with the reduction in deficits likely to be brought about by higher revenues. This might prove to be a challenge as a slowing economy will impact corporate and disposable earnings. At the same time, the notable increase in the non-tax revenue estimates at INR400bn might also prove to be a tall order, if last year is used as a yardstick. Sum of the parts is that the risks of renewed fiscal strain cannot be ignored and bears close scrutiny. The risk is for FY13/14 fiscal deficit to exceed the 4.8% of GDP target by at least 0.5 percentage points.

Rating agencies to monitor developments

Rating downgrade worries have been revived by slow GDP growth, the current deterioration in the current account and the likelihood of fiscal worries making a comeback. Despite the decision by Fitch Ratings to revise the outlook up to ‘stable’ recently, S&P maintains a cautious stance. The latter affirmed the negative outlook on the economy’s long-term and short-term sovereign ratings, reiterating that there was a one-in-third likelihood of a downgrade within the next 12 months. While these remarks caught some quarters by surprise, it was premature to expect the Ministry’s discussions with the rating agencies to have culminated into an upgrade (in the outlook). At best, the discussions helped avert an imminent downgrade.

For one, S&P has set the bar (to avert a downgrade) very high, at least in the short-run. The agency laid out the need to jumpstart public and private investments, revive growth to above 8% and keep the general government’s fiscal and current account deficits under control. A revival in growth by virtue of higher consumption or investments will come at the cost of further deterioration in the current account position. Admittedly, the centre’s fiscal situation improved significantly to end FY12/13 below the official deficit target. However, as explained in the previous section, fiscal disbursements are likely to be scaled up ahead of the elections.

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Getting all the boxes checked over the next one-two years will be a challenge, as we do not anticipate any notable pick up in investments and capex building before the elections. Approach of assembly elections later this year and centre polls mid-2014 will also impede introduction of any big-bang reforms, with indications that the GST tax could be deferred until after the centre elections. The government might find it hard to table and gain approval on key reforms, including the increase in the FDI ceiling for insurance and pension sectors and land acquisition bill. Risks of move to sub-investment category are likely to resurface late-13/early-14 as pre-election spending is ramped up and political worries heighten.

The economy is not as exposed to the sovereign credit markets, as some of the other emerging markets which raise dollar/ foreign currency denominated bonds in the overseas markets. That, however, is not to mean that the impact from the downgrade can be ignored. Revival of these risks could a) materially dent sentiments, lead to further currency depreciation and result in a reversal of foreign flows b) spreads on the offshore loans taken by the domestic corporates/ institutions could rise, along with a possible tightening in the approval process c) investments might fall as select fund houses/ investment managers are deterred to place money in sub-investment grade papers d) Next, the weak rupee could revive familiar woes – high imported inflation, pressure on the current account balance and push real rates to negative terrain. These risks could push the bond yields on the government papers higher. The impact from a possible move to below investment rung might be amplified if the markets in general are in risk-averse mode from the renewed global uncertainty.

Headroom for rate cuts remain narrow

The central bank is likely to be back with its juggling act. Just as the WPI inflation is decelerating, the CPI inflation holds above 9% and renewed rupee depreciation pressures threaten to complicate the inflation-current account dynamics. Policymakers are also cognizant that the anticipated improvement in current account deficit (CAD) is largely driven by external drivers and weak investment appetite, both of which are not desirable. The Bank has stressed on the need for structural improvements, which is yet to materialise.

A possible revival of an accommodative fiscal policy and rupee depreciation might also be of concern to the policymakers. This has seen the RBI stick to its cautious tone in recent official commentary, despite the market pricing in further cuts here on. We had called for 100bps cuts this year, of which 75bp have already been delivered. The base case is for the remaining -25bp to be undertaken before September with the timing contingent on the evolving inflation and current account trajectory. Notably, the recent bear-run in the rupee has raised hurdles to the rate trajectory. All bets for further rate cuts are off the table if rupee remains on the backfoot in the weeks ahead. (please refer to INR sub-section, under Currencies, for our rupee view)

Sources for charts and tables are CEIC Data, Bloomberg, government agencies, RBI and DBS Group Research (forecasts are transformations).

Bets for rate cut off the table if currency resumes free-fall

Impact from potential rating downgrade cannot be ignored

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India Economic Indicators

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12/13 13/14f 14/15f 4Q13 1Q14f 2Q14f 3Q14f 4Q14f 1Q15fReal output (04/05P)GDP 5.0 5.7 6.1 4.8 5.0 5.4 6.0 6.2 6.2

Agriculture 1.9 3.2 4.0 1.4 2.5 3.1 3.5 3.5 3.0Industry (ex constrn) 1.6 4.5 6.0 0.8 3.6 4.1 4.6 5.5 5.0Services 7.2 6.5 6.5 6.5 6.0 6.5 6.7 6.9 7.0Construction 4.4 6.0 6.5 4.4 5.0 5.5 6.0 6.5 6.5

External (nominal)Merch exports (USD bn) 296 315 350 81.9 77.0 75.4 76.0 87.2 92.5

- % YoY -3.3 6.8 11.0 3.2 5.0 8.5 7.0 6.5 6.0Merch imports (USD bn) 491 507 540 128.0 114.5 122.3 136.0 135.0 140.0

- % YoY 0.5 3.3 9.1 2.0 0.2 2.2 5.1 5.4 4.0

Trade balance (USD bn) -195 -192 -190 -46.1 -37.5 -46.9 -60.0 -47.8 -47.5Current a/c balance (USD bn) -94 -86 -96 n.a. n.a. n.a. n.a. n.a. n.a.

% of GDP -5.1 -4.5 -4.2 n.a. n.a. n.a. n.a. n.a. n.a.Foreign reserves(USD bn, eop) 297 305 315 n.a. n.a. n.a. n.a. n.a. n.a.

InflationWPI inflation (% YoY) 7.4 6.7 7.0 6.7 5.4 5.6 7.4 8.4 8.5

OtherNominal GDP (USD tn) 1.9 1.8 1.8 n.a. n.a. n.a. n.a. n.a. n.a.Fiscal balance (% of GDP) -4.9 -5.3 -5.0 n.a. n.a. n.a. n.a. n.a. n.a.

* % change year-on-year, unless otherwise specified** Annual data refers to fiscal years beginning April of calendar year. ***Quarterly data is with reference to calendar year for ease of comparison with other economies

93



94

Economics–Markets–StrategyIndonesia

Eugene Leow • (65) 6878 2842 • [email protected]

IND

ON

ESIA

ID: Commodity headwinds

• GDP growth forecast for 2013 and 2014 is maintained at 6.3% and 6.5% respectively

• While domestic demand has eased, unfavorable commodity prices continue to place pressure on the external accounts

• Depressed commodity prices and burgeoning fuel subsidies have squeezed the budget

• Monetary tightening is likely over the medium term and would be frontloaded if fuel prices get adjusted

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Chart 1: A moderate recovery in investment is expected

Others Net Exports GFCF PCE

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The economic growth pace has clearly moderated over the past several quarters with 1Q GDP reaching 6.0% YoY, down a notch from 6.1% in the preceding quarter. In sequential terms, this translates into a 1.4% QoQ sa increase. Slowing investment was the main reason behind the decline in GDP growth. Notably, gross fixed capital formation contributed just 1.4pct-pt to GDP growth (YoY), compared to an average of 2.4pct-pts in the preceding four quarters. However, this was partially offset by a corresponding fall in imports and resilient private consumption.

Going forward, the economy continues to face headwinds from lackluster commodity prices. This has already manifested in the sizable current account deficit, raising external stability concerns over the past four quarters. There will also be implications on government revenues and on economic growth. These repercussions can place constraints on fiscal and monetary policies going forward. For now, we maintain our 2013 GDP growth forecast at 6.3% with downside risks if fuel prices get revised up. Subsequently, economic growth is expected to accelerate to 6.5% in the run up to parliamentary and presidential elections in 2014.

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IndonesiaEconomics–Markets–Strategy

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Stress on external account persisting

Commodity prices have been unfavorable for the past 4-5 quarters as China’s economic growth cools. In particular, coal, palm oil and industrial metal prices have come down significantly and this has led to a deterioration of Indonesia’s terms of trade. Coupled with robust investment-led domestic demand growth, the trade balance flipped from an average monthly surplus of USD2.2bn in 2011 to an average trade deficit of USD 0.4bn over the 12 months ending April. Notably, the uneven improvement in the external accounts was interrupted when the trade deficit ballooned to USD 1.6bn in April from a surplus of USD 0.3bn in March. This was caused by a likely one-off spike in imports of raw materials and intermediate goods.

Several takeaways can be drawn from the trade numbers. Firstly, investment growth has slowed from the breakneck pace of growth last year and this can be seen by the 19% decline in capital goods imports (average monthly numbers used) in the first four months of the year compared to 4Q12. While this is a negative for GDP growth, a more modest pace of domestic demand growth actually helps to stabilize the external accounts. Secondly, exports are still facing considerable headwinds from depressed commodity prices. In level terms, exports dipped to an eight month low of USD14.7bn in April from a recent peak of USD16.3bn in November 2012. As a result, the trade balance hit a deficit of USD 1.8bn in the four months ending April, compared to a surplus of USD 2.0bn in the same period in 2012.

Monetary policy tightening ahead

To their credit, the monetary authorities have tried to facilitate external adjustments over the past year by raising the FASBI deposit rate by 25bps to 4%, adding macro-prudential measures on car & home loans and tolerating a weaker rupiah to boost export competitiveness. However, these measures have proven to be insufficient especially in light of still-weak commodity prices. External funding risks have again come to the fore in the recent period of portfolio outflows. In order to restore external stability and stabilize the rupiah, Bank Indonesia (BI) is expected to hike the FASBI deposit rate by a total of 75bps to 4.75% by end-2013. This would normalize the corridor between the BI rate and the FASBI deposit rate to 100bps.

Monetary tighten-ing required over medium term

96

Economics–Markets–StrategyIndonesia

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Chart 4: CPI trajectories

Core

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Chart 5: Fuel price impact on PCEQoQ, sa

A 33% hike in fuel prices has no impact

...but a 88% hike in fuel prices stalls PCE growth

Budget feeling the squeeze

Pressure on the budget has also been building as revenues and expenditures get pulled in different directions. Revenue growth has been slow, averaging just 5.7% YoY in the first four months of the year and we suspect that depressed commodity prices have a large role to play. Comparatively, expenditures were up by an average of 20.4% YoY over the same period. Fuel subsidies, which have been largely unchanged since 2005, are to blame as the rising middleclass brought about exponential growth in vehicle ownership. As a result, the rolling 12 months fiscal deficit has been widening steadily since mid-2011. If revenue growth remains lackluster, there are risks that the budget deficit cap of 3% of GDP would be breached. Talks are ongoing about a potential 33% average price hike across subsidized fuels once the revised 2013 budget is passed. However, given uncertainties about the timing and noting that fuel price changes have always met with fierce political resistance, our core scenario does not take into account any adjustment in fuel prices through our forecast horizon.

Growth/inflation dynamics if fuel prices get raised

Assuming that fuel prices get adjusted up by 33% in July, there would be implications on GDP growth, inflation and monetary policy. To gauge the impact on private consumption, we have to go back to the fuel price adjustment episodes in 2005 and 2008. In 2005, fuel prices were raised by 29% in March and again by 88% in October. In 2008, fuel prices were raised by 33% in May (this price increase was reversed in early 2009). During the episodes where fuel prices were raised by around 30%, private consumption growth stalled in the subsequent two quarters, but did not decline. However, when fuel prices were raised by 88%, the slump in consumption was much sharper. With higher incomes, consumers are likely to weather a potential 33% fuel price hike well.

Our core scenario has average 2H13 inflation and 2013 inflation at 5.3%. Comparatively, under a 33% fuel price hike scenario, inflation is likely to average 8.0% YoY in 2H13, bringing 2013 inflation to 6.7%. In order to anchor inflation expectations, BI would likely frontload monetary tightening. In this alternate scenario, the FASBI rate and the BI rate is expected to reach 5.25% and 6.25% respectively by end-2013, compared to our current projection of 4.75% and 5.75% respectively. Taking into account monetary tightening and the stalling of consumption growth, headline GDP growth in 2013 is likely to be shaved by around 0.3pct-pt to 6.0%.

Consumers can handle a 33% fuel price hike

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IndonesiaEconomics–Markets–Strategy

Indonesia Economic Indicators

2012 2013f 2014f 1Q13 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fOutput and DemandReal GDP growth 6.2 6.3 6.5 6.0 6.3 6.1 6.4 6.3 6.6Private consumption 5.3 5.2 5.3 5.2 5.1 5.2 5.4 5.3 5.4Government consumption 1.2 2.7 5.9 0.4 2.2 2.6 4.4 7.6 6.6Gross fixed capital formation 9.8 7.4 8.6 5.9 6.6 8.3 8.4 10.3 8.0

Net exports (IDRtrn, 00P) 240.8 284.9 306.0 77.7 65.2 77.2 64.7 77.3 75.0 Exports 2.0 5.7 7.0 3.4 5.4 7.2 6.6 5.5 5.4 Imports 6.7 2.7 9.0 -0.4 0.3 5.9 4.8 7.5 3.0

ExternalMerch exports (USDbn) 190 184 203 45 45 46 47 48 50- % chg -6.7 -3.4 10.3 -6.4 -7.2 0.3 0.2 6.6 11.0Merch imports (USDbn)** 192 189 210 46 47 47 49 50 52- % chg 8.1 -1.6 11.1 -0.2 -7.5 4.1 -1.9 10.1 10.5Merch trade balance (USD bn)** -2 -5 -7 0 -2 -1 -2 -2 -2

Current account bal (USD bn) -24 -23 -24 n.a. n.a. n.a. n.a. n.a. n.a.% of GDP -2.8 -2.3 -2.0 n.a. n.a. n.a. n.a. n.a. n.a.Foreign reserves (USD bn, eop) 113 110 115 n.a. n.a. n.a. n.a. n.a. n.a.


OtherNominal GDP (USDbn) 871 977 1,162 n.a. n.a. n.a. n.a. n.a. n.a.Fiscal balance (% of GDP) -1.8 -2.7 -2.5 n.a. n.a. n.a. n.a. n.a. n.a.


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ID – policy rate

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98

Economics–Markets–StrategyMalaysia

Irvin Seah • (65) 6878 6727 • [email protected]

MA

LAY

SIA

MY: Expectation lowered

First quarter GDP growth surprised on the downside. The headline number printed 4.1% YoY against a consensus forecast of 5.5%. In fact, almost everyone in the market was looking at growth pace above the 5% mark. In sequential basis, that translates into a contraction of 2.3% QoQ saar (Chart 1). This is down sharply from a robust expansion of 8.1% in the previous quarter.

Strong drag on the external front

An easing off in government spending and investment growth to 0.1% and 13.2% respectively, down from 1.2% and 16% in the previous quarter, have partly contributed to the moderation in growth (Chart 2). This largely reflects the easing off in the earlier pump-priming effort.

On the contrary, private consumption has picked up to 7.5% in the quarter, from 6.2% previously. This can be attributed to the tax breaks, cash handouts as well as the slew of wealth redistribution measures announced in the previous budget and rolled out in the quarter.

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Chart 1: Sharp jolt in 1Q13

% YoY, % QoQ saar

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Net exportsInvestmentGovt expenditurePvt consumptionGDP growth

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Chart 2: More drag from net exports

• Growth has surprised on the downside in 1Q13, which lowered the growth trajectory for the year

• Domestic growth remains resilient but it was the surge in imports that dragged down headline growth

• Full year GDP growth forecast for 2013 has been lowered to 5.0% while growth rate for 2014 is still expected to average 5.5%

• Inflation is picking up but not as fast as predicted. Full year inflation is now likely to average 2.0% in 2013 and 2.4% in 2014

• With growth slower and inflation still benign, Bank Negara is likely to keep policy rate steady at 3.00%

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MalaysiaEconomics–Markets–Strategy

However, the main drag came from the external front. Though export growth improved with a decline of 0.6%, up from the sharper drop of 1.6%, it was the surge in import growth that caused the damage. Imports expanded by 3.6% as compared to the decline of 0.6% in 4Q12.

That is, the recent disappointment in the GDP growth is mainly attributed to the surge in imports and consequently a sharp drop in net exports, rather than weakness in domestic growth. The surge in imports, in fact, reflects strong domestic consumption demand as well as possible restocking by manufacturers. Fundamentally, domestic growth has been holding up, particularly for private consumption.

Positive wealth effects and a buoyant labour market have certainly loosened the consumers’ purse strings. Note that unemployment rate is still low at 3.1% while job vacancies have remained firm, albeit slightly lower (Chart 3). In addition, although investment has eased a little, the growth pace remains in double digit level (13.2%). A strong pipeline of government development projects on the back of the overarching Economic Transformation Programme will continue to drive investment growth in the coming quarters.

Growth forecast lowered

That said, the pace of domestic growth will not be sustainable in the coming quarter. Investor sentiments have turned cautious and the Federal government probably wants to ease off on its pump-priming effort to prevent a build-up in inflationary pressure as well as to ensure longer term fiscal sustainability. Likewise, this will have a knock-on effect on employment outlook and consequently on private consumption. In the meantime, although it appears that the outlook for investment and consumption have moved in opposite direction, we reckon that both will moderate in the coming quarters (Chart 4).

On the external front, the outlook remains dicey. Pockets of risks exist in the developed economies although the market has been pricing in a stronger pace of recovery in the US and the possibility of Fed unwinding on its QE. Uncertainty remains on such expectation given the sequester cuts in spending in the US and the fact that Europe remains stuck in recession. Even the outlook for Asia does not seem to be as rosy as previously anticipated. A broad-based disappointment in Asia economic data in the first quarter and recent sideway moves in key indices in China essentially imply that the growth ahead will be tepid.

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Chart 4: Mixed signals on domestic growthindex

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Chart 3: Labour market still holding up% unit x 1000

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Growth forecast for 2013 revised down to 5.0%

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With the above in mind, we have lowered our full year GDP growth forecast to 5.0%, down from 5.5% previously (Chart 5). However, the growth forecast for 2014 remains unchanged at 5.5% as we expect global outlook to improve gradually, thereby lifting Malaysia’s GDP performance.

Concern on the external balances

Current account surplus is falling rapidly due to the exceptionally strong domestic demand (Chart 6). Latest 1Q13 current account surplus stands at MYR 8.7bn. This is down drastically from the MYR 16.9bn in the same period last year and MYR 22.9bn in the previous quarter. And the main reason for that is the rapid decline in trade surplus (Chart 7).

Overall trade surplus has fallen to MYR 5.1bn as of March, from MYR 10.5bn twelve months ago and a monthly average of MYR 7.9bn in 2012. Apart from a lacklustre export performance due to weak external demand, the trade balance has been significantly dragged down by the relatively stronger imports. Import growth has persistently outpaced export growth (see Chart 8), which led to the rapid declines in trade and current account surpluses.

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Chart 6: Current account surplus falling

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The stronger than usual domestic growth is driving import growth and straining the external balances. It is also having an impact on the currency. Soon after the post election rally, the USD-MYR rate reverted back to the 3.02-3.04 range, and then spiked up to about 3.09 (Chart 9) more recently. While there are other contributing factors such as the expectation of the Fed exiting from QE and pressure from the weak Yen, the decline in the external balances is one of the contributing factors.

So the point is that to reverse the trend on the external balances, either the currency has to depreciate or the domestic interest rates have to rise to cool the domestic demand for imports. For now, it looks like the former is dominating.

Low inflation and slow growth make for stable monetary policy

Indeed, it appears that the central bank is allowing the ringgit to depreciate to take the heat off the decline in the external balances and taking its chance on the inflation. As it is, inflation has been coming in lower than anticipated. Most recent April CPI inflation registered just a benign 1.7% YoY and will at most rise to about 2.4-2.5% by year end (Chart 10).

Even though currency depreciation will risk higher imported inflation, the external inflationary pressure has been low due to weak global growth. Coupled with the domestic price stability (subsidy) programme, which will not be unwound in the near term due to risk of political backlash, inflation is unlikely to rise above the 3.0% level in the coming months. With this is mind, we have lowered our inflation forecast for 2013 and 2014 to 2.0% and 2.4% respectively, down from 2.8% and 3.2% previously.

Importantly, the gap between inflation and the Overnight Policy Rate (OPR) will remain and the real policy rate will stay in the positive range. A slower growth momentum and benign inflation outlook will provide enough justification for Bank Negara (Malaysia) to stand pat on monetary policy and keep the OPR at its current level of 3.00%. As such, we have removed the 50bps rate hikes that we have in our forecast. Policy rate is now expected to remain at the current level through the rest of the year.

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Chart 10: Inflation set to pick up

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Chart 9: Recent pressure on the ringgitMYR/USD

No change to policy rate for 2013

102


Malaysia Economic Indicators

2012 2013f 2014f 1Q13 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandGDP growth 5.6 5.0 5.5 4.1 4.8 5.5 5.4 6.6 5.7

Private consumption 7.7 7.2 7.4 7.5 7.2 7.3 6.8 7.3 7.2Government consumption 5.0 3.0 6.0 0.1 4.0 4.0 3.5 6.2 4.5Gross fixed capital formation 19.9 9.6 6.8 13.2 9.8 8.2 7.5 6.8 6.5Exports 0.1 2.0 6.1 -0.6 1.0 3.7 3.7 7.9 5.9Imports 4.5 4.4 6.9 3.6 3.3 4.4 6.3 4.5 7.1

External (nominal)Exports (USD bn) 231 227 238 56 57 56 58 59 61Imports (USD bn) 199 207 220 51 52 51 53 54 56Trade balance (USD bn) 31 20 18 6 5 5 5 5 4

Current account bal (USD bn) 19 12 8 n.a. n.a. n.a. n.a. n.a. n.a.% of GDP 6 4 2 n.a. n.a. n.a. n.a. n.a. n.a.

Foreign reserves (USD bn, yr-end) 149 157 165 n.a. n.a. n.a. n.a. n.a. n.a.


OtherNominal GDP (USDbn) 304 325 350 n.a. n.a. n.a. n.a. n.a. n.a.Fiscal balance (% of GDP) -4.5 -4.0 -3.6 n.a. n.a. n.a. n.a. n.a. n.a.

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103



104

Economics–Markets–StrategyThailand


THA

ILA

ND

TH: Infrastructure push

• Despite the loss of momentum in 1Q growth, we maintain our GDP growth forecast at 5% for 2013 and 2014

• Inflation has proven to be surprisingly benign. Accommodative monetary policy will provide support for domestic demand growth

• Government-led infrastructure spending will help to lift growth over the medium term, facilitating the economy’s transition to higher-value added industries

GDP growth reached 5.3% YoY in 1Q13, significantly below consensus expectation of a 6.0% expansion. In sequential terms, the economy contracted by 2.2% QoQ sa. Some moderation after the breakneck speed of growth in 4Q12 is inevitable as government spending moderates compared to early 2012, in the immediate aftermath of the flood crisis. Some loss of momentum is also seen in the private sector with gross fixed capital formation and private consumption expenditures down by 3.6% QoQ sa and 1.2% QoQ sa respectively. On the external front, weakness in global demand is starting to show in the goods export numbers. However, weak goods export demand was partially offset by the 25.5% YoY surge in services exports.

Going forward, with the major economies still struggling to find traction, net export is unlikely to be a driver of growth. Instead, maintaining the momentum of the domestic economy and the timely execution of the government’s THB 2.2trn infrastructure plan will be critical in order for Thailand to reach our forecasted 5.0% GDP growth rate for 2013 and 2014. For the longer term, the infrastructure plan has the potential to nudge the economy higher up the value chain and bring about higher trend GDP growth in the coming few years.

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Net Exports Inventories GFCF GCE PCE GDP

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ThailandEconomics–Markets–Strategy

Benign inflation will allow the policy rate to stay low

Monetary conditions to stay easy

The Bank of Thailand (BoT) cut the policy rate by 25bps to 2.50% (the first rate move since October 2012) at the previous monetary policy meeting on 29 May. BoT has been under pressure to reduce interest rates for several months as the THB strengthens significantly against peers in the region, stoking fears that exports may have become uncompetitive. Weak 1Q GDP growth and persistently low inflation have finally given BoT the leeway to ease monetary policy. Notably, headline inflation has fallen to 2.3% YoY in May and annual 2013 inflation is expected to average just 2.9%. With the real policy rate at 0.20% and GDP growth showing signs of strain, pressure on the BoT to further ease monetary policy is likely to persist.

However, we believe that the rate cut is likely to be a one-off adjustment and not the start of an easing cycle. Credit growth has stayed robust with consumer loan growth coming in at 20.7% YoY in March, the highest level in the past eight years. While the growth pace for business loans has moderated, the figure is still fairly strong at 10.3% YoY, compared to the long-term average of 5.9%. Unsurprisingly, BoT has been signaling vigilance by planning a 4% loan loss provision requirement for commercial banks, higher than the industry average of 3.2% and the current requirement of 1%. That said, rates are likely to stay low over the coming few quarters facilitating domestic demand growth.

Revitalizing infrastructure under more realistic assumptions

Economic growth will receive a boost when construction on the THB 2.2trn infrastructure investment plan (land transport development, ports, airports and utilities) begins in 2H this year. Public investment is finally about to be revitalized after many years of stagnation. Since falling off sharply post the Asian financial crisis of 1997/98, real government investment has gone nowhere for more than a decade, while private investment has risen more than two fold since 2000. The spending schedule for the infrastructure projects has been outlined by the government, with nearly 70% of budgeted THB 2.2trn to be disbursed by 2016. Subsequently, spending will taper off through to 2020. Following from these projections, the infrastructure plan in isolation is estimated to add an average of 1.6pct-pt to headline GDP growth annually for the next eight years.

To be sure, what has been highlighted thus far is an optimistic scenario. To complete the analysis, spillover effects and constraints have to be considered. Three potential constraints come to mind. Firstly, can the government afford to take on THB 2.2trn worth of direct/indirect debt? The short answer is yes. Government debt levels are still low with public debt to GDP amounting to around 44%. Assuming that public

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Economics–Markets–StrategyThailand

Tight labor force and stretched banking sector are key challenges

investment spending will provide a boost to GDP size and government revenues, debt levels should barely cross 50% of GDP by 2020.

Secondly, can the workforce handle a sustained increase in demand for construction workers? Possibly, but the current workforce is already stretched with the unemployment rate below 1%. Gauging the construction labor requirement from the planned infrastructure spending, we estimate that 300-400k of additional construction workers will be needed. There are currently around 2.8mn construction workers with around 0.25mn people unemployed. Even under the heroic assumption that all the unemployed people are willing to become construction workers, there would be a shortfall of workers.

Thirdly, some crowding out effect on private sector investment is probable. As a more developed economy, Thailand’s loan-to-GDP ratio and loan-to-deposit ratios are both close to 100%. Accordingly, this implies less room for the financial sector to extend credit, unless the financial sector is willing to draw in foreign funding. However, excessively strong private and public investment would risk macroeconomic stability as the current account deteriorates and debt levels continue to build up. Factoring in execution risk and macroeconomic constraints, a more conservative assumption that only 50% of the planned public infrastructure spending would take place appears more logical. Taking into account spillovers into imports and private consumption, the net positive impact on headline GDP would be around 0.5-1.0 pct-pt each year. If government infrastructure spending fails to materialize in 2H this year, GDP growth would be lower by 0.4pct-pt, translating into 2013 growth of 4.6%.

Taking the lead in the Greater Mekong Region

Even under more conservative assumptions, the improvement in transport infrastructure in the coming years still offers Thailand an opportunity to break out of the middle income trap. Located in the middle of the Greater Mekong Region, comprising of Cambodia, Laos, Myanmar, Vietnam and China, constructing overland routes amongst these countries offers enormous potential for trade volume growth as the region develops. Leveraging its position as one of the most advanced economy in the greater Mekong region, Thailand has been increasing direct investment into neighboring countries. Over time, more manufacturing activities are likely to be outsourced as Thailand moves up the value chain and takes full advantage of the lower labor costs of its neighbors.

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ThailandEconomics–Markets–Strategy

Thailand Economic Indicators

2012 2013f 2014f 1Q13 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandGDP growth (88P) 6.4 5.0 5.0 5.3 5.0 5.5 4.2 4.7 4.8

Private consumption 6.7 3.3 5.5 4.2 3.3 3.4 2.4 6.6 4.9Government consumption 7.5 1.1 5.9 2.2 -0.4 0.0 3.0 10.3 7.5Gross fixed capital formation 13.2 3.8 7.6 6.0 3.2 1.3 5.3 8.6 7.7

Net exports (THBbn) 660 754 778 205 185 157 207 215 176 Exports 3 6 5 8 7 5 5 2 3 Imports 6 4 5 8 2 6 2 1 6

ExternalMerch exports (USDbn) 226 238 269 56 59 60 62 63 64

- % YoY 3 5 13 4 4 2 10 7 0Merch imports (USDbn) 219 232 267 57 56 58 60 61 62

- % YoY 8 6 15 9 2 6 7 6 0Trade balance (USD bn) 7 6 2 -1 3 3 2 2 2Current account balance (USD bn) 1 1 2 1 1 4 1 1 2

% of GDP 0.7 1.1 0.7 n.a. n.a. n.a. n.a. n.a. n.a.


OtherNominal GDP (USDbn) 366 412 464 n.a. n.a. n.a. n.a. n.a. n.a.Unemployment rate, % 0.5 0.6 0.6 n.a. n.a. n.a. n.a. n.a. n.a.Fiscal balance (% of GDP)** -2.9 -2.4 -2.3 n.a. n.a. n.a. n.a. n.a. n.a.

* % change, year-on-year, unless otherwise specified** Central govt cash balance for fiscal year ending September of the calendar year

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Economics–Markets–StrategySingapore


SIN

GA

POR

E

SG: Not as bad

Once again the Singapore economy bounced back to expansion even when the advance estimates, and indeed almost everyone in the market, had predicted a contraction in the quarter. Based on the final GDP figures for 1Q13 announced recently, the economy expanded by 1.8% QoQ saar (0.2% YoY). This is a significant upward revision from the advance estimates of -1.4% QoQ saar (-0.6% YoY) (Table 1).

More importantly, we had correctly pointed out that stronger services and construction growth will be the main reason for the revision although the manufacturing growth will turn out slightly worse than expected.

Signs of manufacturing sector recovery

Indeed, growth momentum in the manufacturing has been sluggish in the first two months of the year due to the festive season slump and an unexpected pullback in pharmaceutical production. While output did rebound in March, the turnaround was below expectation. An uncertain global outlook and sluggish external demand is the reason behind the below-par show.

Yet, one also should not discount the strain on corporate earnings exerted by the restructuring effort, which has led to the sharp increase in business costs as well as decline in competitiveness. But there have been some recent signs of recovery.

Table 1: GDP growth by sectors1Q12 2Q12 3Q12 4Q12 2012 1Q13

Overall GDP 1.5 2.3 0.0 1.5 1.3 0.2Manufacturing -1.2 4.1 -1.4 -1.1 0.1 -6.8Construction 9.4 11.4 6.7 5.8 8.2 7.3Services producing 2.1 1.1 0.0 1.7 1.2 2.7

Overall GDP 7.8 0.1 -4.6 3.3 1.3 1.8Manufacturing 13.8 -1.0 -16.6 3.1 0.1 -12.3Construction 10.5 15.0 3.2 -3.9 8.2 16.5Services producing 3.5 0.1 0.4 2.5 1.2 7.9

Percentage change year-on-year

Quarter-on-quarter annualised growth rate, seasonally adjusted

• First quarter growth turned out not as bad as what was predicted previ-ously. Headline growth registered an expansion of 1.8% QoQ saar (0.2% YoY)

• Key manufacturing and services sectors are seeing gradual improvement in growth outlook

• GDP growth is expected to average 2.5% in 2013 and 4.0% in 2014

• Inflation has fallen due to sharp corrections in the COE premiums. Full year inflation is expected to register 2.8% in 2013 and 3.6% in 2014

• With growth outlook improving and inflation easing, the Monetary Au-thority of Singapore (MAS) is expected to maintain the appreciation of the Sing NEER in the upcoming October review

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SingaporeEconomics–Markets–Strategy

As a matter of fact, industrial production output growth for April has came in better than expected. Output expanded by 4.7% YoY and 2.5% MoM sa (Chart 2). Notably, the electronics cluster recorded its first ever year-on-year expansion in two years while the pharmaceutical segment surged by 45% YoY.

Although some base effect is at play, particularly for the pharmaceutical cluster, this good showing will certainly have a positive impact on the manufacturing growth performance in 2Q13 after the disappointment in the first quarter. So plainly, while the near term outlook for the manufacturing sector remains dicey, there is light at the end of the tunnel.

Services sector performance is still key

Nonetheless, the crux of the issue lies in the performance of the services sector. This sector accounts for about 70% of the overall economy. Historically, the performance of the economy is closely tied to it. If the services sector turns, the economy turns along with it (Chart 2).

This sector surged 7.9% QoQ saar in the first quarter, compared to the earlier prediction of just 1.8% in the advance estimates. This is the story behind the massive upward revision. Growth in this sector is still supported by expansion in the financial,

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Turnaround in both manufactur-ing and services sectors

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business and other services sectors. We expect growth in this sector to remain firm in the coming quarters against the backdrop of a gradual improvement in economic conditions in the region. Separately, the construction sector has continued to maintain a healthy pace of growth. A strong pipeline of private residential and public transportation projects has continued to drive growth in this sector.

Growth forecast on track

Despite pockets of risk in the developed economies, a gradual improvement is ex-pected in the coming quarters. The disappointment over the US and China eco-nomic growth will pass and global growth momentum will pick up, albeit slowly. These will likely lend support for the Singapore economy in the coming quarters.

However, the economy is hampered by the current restructuring process. The supply side constraint due to the curbs in inflow of foreign workers imposed by the government has continued to weigh down on growth performance. So despite the anticipated gradual cyclical improvement in the second half of the year, the growth outlook remains weighed by this structural drag. Our forecast for the full year remains at 2.5% (Chart 3). Growth forecast for 2014 remains unchanged at 4.0%.

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Inflation dipped sharply on COEs correction

Inflation plunged on COEs correction

Meanwhile, April inflation unexpectedly plunged to just 1.5% YoY. That’s a massive 2%-pt drop from 3.5% in the previous month. While everyone in the market had expected a significant moderation, it appears that the correlation between the plunge in COE premiums and the CPI inflation had been underestimated.

Indeed, the drop in the transport CPI inflation has been the key factor (Chart 4). In particular, it was due to the private transport cost index, a sub-index of transport CPI, which on its own accounts for a significant 11.7% of the overall CPI basket and this sub-index is mainly driven by the COE premiums. So considering the fact that average COE premium has dived by about 20% YoY in April, it probably explains why the headline inflation figure has dropped so drastically.

Tighter financing terms on car purchases introduced by the MAS earlier have hit car demand. Essentially, cars with an Open Market Value (OMV) that do not exceed SGD 20,000 will now face a maximum loan to value (LTV) of 60%. For a motor vehicle with OMV of more than SGD 20,000, the maximum LTV is now 50%. This is down from a maximum LTV of 100% previously. Further, the tenure for vehicle loan has also been capped at 5 years.

These changes essentially imply substantially more cash up-front for consumers, which in effect, have slammed the brakes on car demand and COEs. This is the main reason why COE premiums have fallen sharply and thereby creating the significant knock-on effect on CPI inflation (Chart 5).

However, underlying cost pressure is still high and the labour market is still tight. Wage pressure is expected to rise in the later part of the year when growth momentum picks up. Moreover, such pullback in inflation as a result of the policy shift will be transient and will probably last for only 12 months before its impact on inflation lapses due to base effect. In fact, inflation is expected to rise above the 3% level from April next year onwards unless there is more disinflationary pressure.

But in the near term, the point to note is that this major policy change has drastically lowered the trajectory of the inflation profile. That is, full year inflation will be significantly lower than previously anticipated due to this policy shift. With this in mind, full year inflation for 2013 is now expected to average 2.8% while inflation for 2014 is likely to come in at 3.6%.

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Status quo on the exchange rate policy

The Monetary Authority of Singapore (MAS) has maintained its policy of a modest and gradual appreciation of the SGD NEER policy band in the last review in April. There have been no change to the slope and width of the policy band, as well as the level at which it is centred. The authority deemed that this policy stance is appropriate for containing inflationary pressures, anchoring inflation expectations, and facilitating the restructuring of the economy towards sustainable growth.

Since then, inflation has eased while growth has turned out slightly stronger than expected. That implies more breathing space for policymakers in terms of managing the risks between growth and inflation. Although the USD/SGD has spiked lately due to market expectations of an early unwinding of the QE by the US Fed, and that the SGD NEER has also trend towards the lower half of the band, we believe the authority will likely continue to maintain the current stance in the forthcoming meeting in October (Chart 6 & 7). Ultimately, inflation is set to inch higher on account of rising wage pressure. And growth should return to the medium term potential growth level by 2014. That makes the case for a gradual appreciation of the SGD NEER in the coming quarters.

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MAS to stand pat

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Singapore Economic Indicators

2012 2013f 2014f 1Q13 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandReal GDP (00P) 1.3 2.5 4.0 0.2 1.5 4.0 4.4 5.0 4.1

Private consumption 2.2 2.0 3.0 1.6 1.8 2.1 2.5 2.7 3.2Government consumption -3.3 7.3 2.7 14.5 3.4 3.7 7.4 1.3 3.0Gross fixed investment 7.4 1.9 4.1 -4.7 3.4 4.0 5.0 4.3 5.0Exports 0.3 0.6 4.1 -4.2 -1.2 1.0 6.9 5.5 4.3Imports 3.2 -0.6 3.9 -2.4 -1.4 -1.5 3.0 3.6 4.3

Real supplyManufacturing 0.1 -0.5 2.9 -6.8 -2.8 3.8 4.1 6.6 3.4Construction 8.2 5.2 4.1 7.3 8.1 3.1 2.8 4.1 4.1Services 1.2 3.9 4.4 2.7 3.4 4.3 5.1 4.6 4.4

External (nominal)Non-oil domestic exports 0.5 0.8 2.9 -12.5 0.7 6.7 9.2 4.7 2.0Current account balance (USD bn) 51 54 57 n.a. n.a. n.a. n.a. n.a. n.a.

% of GDP 18 18 18 n.a. n.a. n.a. n.a. n.a. n.a.Foreign reserves (USD bn) 259 272 281 n.a. n.a. n.a. n.a. n.a. n.a.


OtherNominal GDP (USDbn) 277 292 312 n.a. n.a. n.a. n.a. n.a. n.a.Unemployment rate (%, sa, eop) 2.0 2.2 2.5 1.9 2.0 2.1 2.2 2.3 2.4

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Economics–Markets–StrategyPhilippines


PHIL

IPPI

NES

PH: Fastest

• Our GDP growth forecast for 2013 has been revised up to 6.4% while the projection for 2014 is unchanged at 6.0%

• Amid abundant liquidity, low inflation and no external account concerns, interest rates are going to stay low

• Low rates will facilitate domestic demand growth, enabling the economy to attain trend growth of 6-7% even with lackluster external demand

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CN

GDP growth reached 7.8% YoY in 1Q13, the fastest in Southeast Asia and ahead of China. The headline growth figure has held above 7% for the past three quarters and is all the more impressive in 1Q as base effects are no longer favorable. In sequential terms, GDP expanded by an annualized 8.8%. Domestic economic strength was the main reason GDP held up so well despite a hefty external drag. Notably, early signs of investment-led growth are starting to show with gross fixed capital formation growth rising by double digits for three straight quarters (YoY). Coupled with acceleration in government spending and resilient private consumption, domestic demand grew by 8.4% YoY. On the external front, the 7% YoY decline in exports (largely due to weak electronics demand) was the largest drag on headline growth.

The economy is currently in an extended sweet spot of strong growth and low inflation, with limited economic constraints on policy making. Supported by low interest rates, the domestic economy is resilient enough to propel GDP growth to a higher growth plane of 6-7% even if external demand remains lackluster. On the back of the higher-than-expected 1Q GDP figure and resilient domestic demand, we have upgraded our 2013 GDP growth forecast to 6.4% (from 6.0% previously) even as we account for a tapering off in election-related spending in 2H13. For 2014, our forecast remains unchanged at 6.0%.

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ID MY PH CN

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PhilippinesEconomics–Markets–Strategy

Excess liquidity has been stuck in the SDAs

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Interest rates are going to stay low

Driven by capital inflows and BSP’s policies (the reverse repurchase rate has been kept at an all-time low of 3.5% since October 2012), interest rates have fallen sharply over the past few years. The average prime lending rate (offered by commercial banks) has fallen by 178bps to 4.8% since the peak in March 2012. Meanwhile, 10-year government bond yields have fallen by roughly the same magnitude to 3.5% over the time period. Looking further back, long-term government borrowing costs have dropped by 300bps since April 2011.

Interest rates are likely to stay low for two key reasons. Firstly, excess liquidity in the financial system remains abundant as represented by the PHP 1.9trn worth of funds placed in the special deposit accounts (SDAs, used for liquidity management purposes), the recent bout of portfolio outflows notwithstanding. Secondly, monetary policy is not constrained by inflation or external stability worries. Growth/inflation dynamics remain sanguine. Despite robust GDP growth, inflation stayed at an eight-month low of 2.6% in May amid lackluster commodity and stable food prices. The same can be said for external dynamics with the current account registering a surplus of 2.9% of GDP in 2012, supported by remittances and services exports. The sizable current account surplus implies plenty of room for investment-led growth to take place without threatening external stability. Considering also the low financial leverage in the economy, there is leeway for BSP to keep the reverse repurchase rate low, supporting the domestic economy.

Directing liquidity

That said, channeling the excess liquidity to productive uses has proved challenging with the 150bps worth of cuts to the SDA rate to 2% not having the desired effects of shifting funds out of SDAs. However, we think that a combination of push and pull factors imply that a rotation of funds out of SDAs into other financial instruments such as deposits is inevitable. With the rate of return on SDAs slashed sharply, banks have an incentive to adjust their balance sheet mix, implying a greater propensity to take on government bonds and private sector credit. To be sure, there are other considerations affecting the optimal allocation of banks’ portfolio. These include potential restraints due to capital adequacy requirements, reserve requirements and the higher level of risks involved when shifting away from a risk-free asset. However, on balance, banks would rotate out of SDAs if there is sufficient demand for credit (assets to diversify into), a case that is likely to materialize going forward. Moreover, in late May, BSP further restricted trust funds’ (which make up a large proportion of SDA funds) access to the SDAs with effect from 2014.

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Economics–Markets–StrategyPhilippines

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This portfolio reallocation can be quite sizable considering that “cash and due from banks” (including SDAs) account for an estimated 27% of total banking assets. Comparatively, the loan portfolio accounts for only 49% of bank assets. Such a development would be worrisome if debt ratios are high and credit growth is rampant but this has not been the case. Credit growth has averaged 16% over the past two years and a higher growth figure can be tolerated given the low inflation levels.

Making use of the liquidity

The private and public sectors will benefit from low rates. With banks able to extend credit, more government financing can be done domestically. Over the past few years, the government has been relying less on foreign financing; the ratio of foreign debt outstanding to total debt outstanding fell to 36% in 2012 from 49% in 2003. With ample liquidity in the financial system, the government may be able to do away with foreign financing entirely in 2013, better managing its external liabilities with little risk of any crowding out effect. To put things into perspective, the government intends to borrow PHP 730bn this year, about one-third the size of excess liquidity in the financial system.

Private sector financing needs for investment purposes is expected to increase. In the near term, progress on the 22 private-public-partnership projects (PPP) launched in late 2010 will be key to watch. To date, eight projects (total value of PHP 106bn) have been approved and three project contracts have been awarded. Foreign private sector interest has also been strong with investment pledges reaching a record USD 15.9bn (PHP 650bn) in 2012. Aggressive promotion of the country as the investment destination of choice by the current administration is also likely to bear fruit this year.

The current period offers an opportunity to accelerate investment and growth overall. Average gross fixed capital formation (GFCF) growth has languished at 5.4% over the last decade, but this should move closer to 7% going forward. We believe GFCF will rise to 25% of GDP over the coming decade from 20% currently. This would lift GDP to a higher growth plane of 6%-7%, compared to the average rate of 4.7% since the Asian Financial Crisis of 1997/98.

Low rates will ben-efit the domestic economy

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PhilippinesEconomics–Markets–Strategy

Philippines Economic Indicators

2012 2013f 2014f 1Q13 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandReal GDP growth 6.8 6.4 6.0 7.6 6.3 6.3 5.5 5.3 5.4

Private consumption 6.6 5.2 5.7 5.1 5.2 4.7 5.5 5.4 6.1Government consumption 12.2 10.0 2.3 13.2 10.2 8.4 7.7 1.8 1.0Gross fixed capital formation 10.4 11.3 7.8 16.8 13.7 11.1 4.7 6.6 9.6

Net exports (PHP bn, 00P) 47.7 -48.9 -51.8 2.9 35.1 25.0 -111.8 -8.6 21.3 Exports 8.9 -2.8 5.1 -7.0 -3.3 1.3 -2.2 3.8 1.8 Imports 5.3 0.4 5.1 1.6 -0.8 0.8 0.1 5.4 3.6

External (nominal)Merch exports (USD bn) 52.0 53.5 58.5 12.1 13.3 13.9 14.2 14.4 14.6

- % YoY 7.6 2.9 9.4 -6.2 -4.2 4.4 19.0 19.2 9.4Merch imports (USD bn) 61.7 62.0 68.1 14.4 15.4 15.9 16.3 16.6 16.9

- % YoY 2.0 0.4 9.9 -7.4 1.0 4.0 4.0 15.6 9.7Merch trade balance (USD bn) -9.7 -8.5 -9.6 -2.3 -2.1 -2.0 -2.1 -2.2 -2.4

Current account balance (USD bn) 8 7 7 n.a n.a n.a n.a n.a n.a% of GDP 2.8 2.6 1.9 n.a n.a n.a n.a n.a n.a

Foreign reserves, USD bn 84 88 95 n.a n.a n.a n.a n.a n.a


OtherNominal GDP (USD bn) 250 290 323 n.a n.a n.a n.a n.a n.aBudget deficit (% of GDP) -2.3 -2.5 -2.2 n.a n.a n.a n.a n.a n.aGovt external debt (USD bn) 48 48 48 n.a n.a n.a n.a n.a n.a

% of GDP 19 17 16 n.a n.a n.a n.a n.a n.a


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2012 2013f 2014f 1Q13 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandReal GDP growth 6.8 6.4 6.0 7.8 6.3 6.3 5.5 5.3 5.4

Private consumption 6.6 5.2 5.7 5.1 5.2 4.7 5.5 5.4 6.1Government consumption 12.2 10.0 2.3 13.2 10.2 8.4 7.7 1.8 1.0Gross fixed capital formation 10.4 11.3 7.8 16.8 13.7 11.1 4.7 6.6 9.6

Net exports (PHP bn, 00P) 47.7 -48.9 -51.8 2.9 35.1 25.0 -111.8 -8.6 21.3 Exports 8.9 -2.8 5.1 -7.0 -3.3 1.3 -2.2 3.8 1.8 Imports 5.3 0.4 5.1 1.6 -0.8 0.8 0.1 5.4 3.6

External (nominal)Merch exports (USD bn) 52.0 53.5 58.5 12.1 13.3 13.9 14.2 14.4 14.6

- % YoY 7.6 2.9 9.4 -6.2 -4.2 4.4 19.0 19.2 9.4Merch imports (USD bn) 61.7 62.0 68.1 14.4 15.4 15.9 16.3 16.6 16.9

- % YoY 2.0 0.4 9.9 -7.4 1.0 4.0 4.0 15.6 9.7Merch trade balance (USD bn) -9.7 -8.5 -9.6 -2.3 -2.1 -2.0 -2.1 -2.2 -2.4

Current account balance (USD bn) 8 7 7 n.a n.a n.a n.a n.a n.a% of GDP 2.8 2.6 1.9 n.a n.a n.a n.a n.a n.a

Foreign reserves, USD bn 84 88 95 n.a n.a n.a n.a n.a n.a


OtherNominal GDP (USD bn) 250 290 323 n.a n.a n.a n.a n.a n.aBudget deficit (% of GDP) -2.3 -2.5 -2.2 n.a n.a n.a n.a n.a n.aGovt external debt (USD bn) 48 48 48 n.a n.a n.a n.a n.a n.a

% of GDP 19 17 16 n.a n.a n.a n.a n.a n.a


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Economics–Markets–StrategyVietnam


VIE

TNA

M

VN: Turning dicey again

Growth has slowed and inflation has dipped. Calls for more monetary easing has intensified. And the State Bank of Vietnam (SBV) is once again under pressure to act. The authority responded, cutting the policy rates by a total of 200bps year to date. This is after a total of 600bps cuts in 2012. The question now is whether there will be more loosening going forward and will that lead to another bout of high inflation?

Is monetary policy easing coming to an end?

As it is, GDP growth in the first quarter has slumped to 4.9% YoY(Chart 1), down from 5.5% in 4Q12. Economic activity has slowed on the back of the earlier monetary tightening as well as the weak global outlook. Full year GDP growth for 2013 is now expected to register 5.3%, down from our previous forecast of 5.5%. Growth forecast for 2014 has also been lowered to 5.7%, from 6% previously

As a result of the sharper than expected moderation in the growth pace, the central bank cut rates by 100bps in Mar13 and a further 100bps in May. The refinance rate has been lowered to 7.00% while the discount rate has been shaved to 5.00%. Apart from the slowdown in growth, the rapid decline in inflation has probably

• Growth has moderated while inflation has eased faster than expected

• GDP growth is now likely to register 5.3% in 2013 and 5.7% in 2014

• Inflation is expected to average 6.7% in 2013 and remain fairly unchanged at 6.8% in 2014

• But that’s on condition that the central bank ends the current easing cycle and refrains from cutting rates further, else inflation will pick up later

• Trade deficit has widened lately while the dong has been forced to devalue

• Economic conditions have turned dicey again

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VietnamEconomics–Markets–Strategy

also provided the impetus for the central to ease off on monetary policy. Most recent Apr13 inflation registered 6.4%, down significantly from the previous peak of 23% in Aug11.

However, we reckon that the State Bank of Vietnam is probably at the end of its easing cycle after the most recent rate cuts. Essentially, the recent rate cuts can be seen as a continuation of the monetary easing cycle that started in early 2012. Cumulatively, the central bank has already lowered the policy rates by 800bps in this easing cycle. That’s more than what it has taken from the market when it hiked a total of 700bps between Nov10-Oct11 (Chart 2).

The real discount rate is already negative and the real refinance rate is just barely in the positive range. That is, further monetary easing may well push the real policy rates into negative levels and hence, sow the seeds for another bout of high inflation down the road.

In addition, inflation risk could curtail further monetary easing. Although inflation has eased, it appears to have bottomed (Chart 3). Latest May inflation registered 6.4% YoY, down from 6.6% in the previous month. The trajectory appears to have flattened and in fact, the month-on-month change has been negligible over the last two months.

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Easing cycle end-ing

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Economics–Markets–StrategyVietnam

Beyond that, inflation may rise, especially if global growth momentum is expected pick up pace in the coming quarters. With that, the headline number is likely to rise towards the 7% mark next year. Moreover, the official inflation target for the year stands at 6.5-7%. This implies that the current policy rates are probably at their lowest without stoking another bout of inflation subsequently. Our expectation is for the headline CPI inflation to average 6.7% this year and 6.8% in 2014.

Risks on monetary policy

The existing bad debt problem in the banking system is another concern, which could prompt the central bank to cut rates more than required. As it is, bad debt ratio in the country is estimated to be around 6%, according to the official estimate. And credit growth is anaemic, at a mere 2% in the first four months of the year, down from 9% in 2012.

Thankfully the SBV plans to force financial institutions to sell their non-performing loans to a soon-to-be established asset management company rather than by merely lowering the financing cost to resolve the bad debt problem in the country. Lenders with bad-debt ratios of 3% and above will be required to comply. This is believed to be able to clear up nearly USD 5bn worth of bad debt, as the government steps up its banking overhaul efforts.

Challenging economic conditions call for careful calibration in the current monetary easing cycle. The economy has a poor track record in terms of its inflation targeting ability. Premature or too aggressive easing will most likely spark another bout of high inflation. History has already repeated itself twice in this regard. With that, the policy rates should remain where they are to ensure that the real policy rates remain in the positive territory. Ultimately, controlling inflation remains the key to ensuring economic stability in Vietnam.

Concerns on the trade balance

There have been some worrying signs on the external balance too. Overall trade balance fell to a deficit of USD 1.2bn in May, compared to a monthly average trade surplus of USD 167mn in 2012. This is a huge drop and certainly has added significant pressure on the domestic currency. The dong depreciated by 0.4% in May to 21013, from 20930 in the previous month.

Moreover, the depreciation in the local currency probably also reflected the market concern regarding the latest rate cut by the central bank. Nonetheless, as we’ve pointed out previously, the SBV is probably at the end of its easing cycle. And if the outlook in the global economy picks up in the later part of the year, exports could improve and the trade deficit may narrow. The pressure of the dong will ease consequently. Meanwhile, the SBV must stay vigilant on inflation and must stand ready to act should inflationary pressure picks up stronger than expected.

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Economic condi-tions have turned dicey again

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Vietnam Economic Indicators

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Real supplyAgriculture & forestry 2.7 3.4 3.6 2.2 3.4 3.0 4.1 3.6 3.5Industry 5.2 5.2 5.7 4.9 5.2 5.3 5.4 5.5 5.6Construction 2.1 3.6 6.4 4.8 3.1 4.2 3.0 -0.8 5.5Services 6.4 6.1 6.3 5.6 5.7 6.3 6.5 6.3 6.3

External (nominal)Exports (USD bn) 114.4 132.0 145.1 29.6 32.1 34.3 36.0 33.8 35.4Imports (USD bn) 112.4 131.2 143.4 29.5 33.9 33.2 34.6 33.6 37.7Trade balance (USD bn) 2.0 0.9 1.7 0.1 -1.8 1.1 1.4 0.2 -2.2

Current account bal (USD bn) 3.5 2.0 3.2 n.a. n.a. n.a. n.a. n.a. n.a.% of GDP 2.5 1.3 1.8 n.a. n.a. n.a. n.a. n.a. n.a.


OtherNominal GDP (USDbn) 142 158 177 n.a. n.a. n.a. n.a. n.a. n.a.Unemployment rate (%, sa, eop) 4.8 5.0 4.8 n.a. n.a. n.a. n.a. n.a. n.a.

- % change, year-on-year, unless otherwise specified- Figures may differ from official sources due to difference in reporting format

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Economics–Markets–StrategyEconomics: United States

The March, April and May data have been weak. This led the Fed, in its May FOMC statement, to tell investors that QE3 could be dialled up as well as down. Few seem to have taken the Fed seriously, even after Bernanke testified before Congress that the economy “is not where we want it” and that easing back on QE could cause the economy to stall and lead to lower, not higher, interest rates for an extended period of time. Notwithstanding, yields on 10Y Treasuries have risen by 25bps-35bps since early-May as investors brace for a tapering of QE that some FOMC members would like to begin as early as June.

The trees

The ISM dropped to 49 in May. That’s not just weak, that’s ‘negative’. And it’s not a one-off. The ISM has fallen from 54.2 back in February (not very high to begin with, in other words), to 51.3 in March, 50.7 in April and, now, 49 in May. Most would call that a trend. The orders component, moreover, dropped by 3.5 points to 48.8.


UN

ITED

STA

TES

US: comme ci, comme ca

• The data have been weak in March, April and May

• The Fed has advised markets that QE3 can be dialled up as well as down

• Nonetheless, markets fear a tapering. 10Y Treasury yields are 25bps-35bps higher than they were 6 weeks ago

• Bernanke would like to see more data before deciding on QE3

• Growth remains slow; inflation continues to fall. And the impact of $85bn of sequester cuts has yet to be seen

• Not for nothing does Bernanke want to sit tight

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Economics: United StatesEconomics–Markets–Strategy

So investors shouldn’t be looking for a rebound next month. Currently at its lowest point since June 2009, it could drift lower yet in July.

April auto sales clawed back some of their March losses but this key sector illustrates the lethargy on the demand side of the equation and the downward movement in the ISM. Sales of domestically produced vehicles stood at 12mn units in April, exactly where they were back in November 2012. Seven months at 12mn, 6 months of zero growth. Little wonder the ISM is back below 50.

The forest

Step back from the trees. Does the forest look any different? Not really. Consumption – the ultimate driver of all things – is on track for 2% (QoQ, saar) growth in Q2. That’s just what it’s averaged for the past four quarters and for the past eight quarters. Slow and steady in other words.

Investment? Durable goods orders have run sideways for the past year (chart below). Business investment in the GDP accounts grew by 2.2% (annualized) in the first quarter. Government? It’s trying to cut the budget and, thanks to the $85bn of sequester cuts, it is making a lot of progress (chart at top of next page).

Auto sales have run sideways for 7 months. Little wonder the ISM is back below 50

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Economics–Markets–StrategyEconomics: United States

The budget deficit will fall sharply in 2013, ironically thanks to congres-sional inaction that brought the sequester

Add it all up and GDP growth comes to 1.4%, on average, over the past two quarters, down from 1.8% averaged over the past eight. Conclusion? Growth in the broader economy is running slower on the margin, not faster.

Inflation and the Fed

Slower growth on the margin has allowed inflation to drift ever lower. Core CPI inflation has fallen to 1.7% YoY as of April and core PCE inflation – the Fed’s favored gauge – has dropped all the way to 1.1%. The latter is barely half the Fed’s target rate. Nevertheless, several FOMC members would like to wind down QE3, believing that the risks of inflation and asset bubbles are high and rising.

Bernanke believes this unwise. He recently told Congress that inflation is low and falling, as it is, and that asset markets do not appear “inconsistent” with economic fundamentals.

We’ve seen this before. Fourteen months ago, at its April committee meeting, the FOMC upgraded its outlook for the economy. Several officials began talking publicly about the possibility of raising interest rates by year-end (2012). Two months later, all such talk had vanished. By August, Bernanke was announcing QE3.

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Economics: United StatesEconomics–Markets–Strategy

US Economic Indicators

Sources for charts and tables are CEIC Data, Bloomberg and DBS Group Research (forecasts are transformations).

The economy is running no faster than it was 14 months ago. Much of the recent data have looked very poor. And the impact of the sequester cuts has yet to be seen. Not for nothing does Bernanke want to sit tight. He will prevail.

Markets currently price in a first Fed hike in March of 2015. This does not seem unreasonable but the risk is that hikes come later not sooner. Much of the improvement in the unemployment rate, which Fed hikes hinge upon, has been for the wrong reason: people are dropping out of the labor force (and not being counted as unemployed). A better economy would, we believe, bring them back into the labor force and slow the (anyways superficial) improvement in the unemployment rate seen to date.

Markets have a first Fed hike priced in for March 2015. The risks is that hikes come later, not sooner

2012 --- 2013 --- -- 2014 --2012 2013(f) 2014(f) Q4 Q1 (f) Q2 (f) Q3 (f) Q4 (f) Q1 (f) Q2 (f)

Output & DemandReal GDP* 2.2 1.6 2.2 0.4 2.4 1.2 1.4 1.8 2.6 2.6

Private consumption 1.9 2.2 2.2 1.8 3.4 2.0 2.0 2.1 2.2 2.2Business investment 8.0 4.3 6.3 13.1 2.2 3.0 4.0 5.0 7.5 7.5Residential construction 12.1 13.6 11.1 17.5 12.0 14.0 14.0 12.0 10.0 10.0Government spending -1.7 -3.6 -1.2 -7.0 -4.9 -4.0 -4.0 -2.5 0.0 0.0

Exports (G&S) 3.4 2.3 6.1 -2.8 0.8 4.8 6.2 6.2 6.2 6.2Imports (G&S) 2.4 1.8 5.9 -4.2 1.9 5.0 6.0 6.0 6.0 6.0Net exports ($bn, 05P, ar) -401 -399 -420 -385 -392 -397 -402 -407 -412 -417Stocks (chg, $bn, 05P, ar) 43 36 35 13.3 38.3 35.0 35.0 35.0 35.0 35.0

Contribution to GDP (pct pts)Domestic final sales (C+FI+G) 2.1 1.8 2.4 1.8 2.1 1.4 1.5 2.0 2.7 2.7Net exports 0.1 0.0 -0.1 0.3 -0.2 -0.2 -0.1 -0.1 -0.1 -0.1Inventories 0.1 -0.1 0.0 -1.4 0.7 -0.1 0.0 0.0 0.0 0.0

InflationGDP deflator (% YoY, pd avg) 1.8 1.9 1.9CPI (% YoY, pd avg) 2.1 1.6 2.0 1.9 1.7 1.4 1.6 1.8 2.0 2.0CPI core (% YoY, pd avg) 2.1 1.7 1.7 1.9 1.9 1.7 1.6 1.6 1.6 1.7PCE core (% YoY, pd avg) 1.7 1.2 1.4 1.5 1.3 1.1 1.0 1.2 1.3 1.3

External accountsCurrent acct balance ($bn) -475 -505 -509Current account (% of GDP) -3.0 -3.1 -3.0

OtherNominal GDP (US$ trn) 15.7 16.3 17.0Federal budget bal (% of GDP) -6.8 -4.0 -3.8Nonfarm payrolls (000, pd avg) 206 155 165 170 175 185 190Unemployment rate (%, pd avg) 7.8 7.7 7.6 7.7 7.7 7.5 7.5

* % period on period at seas adj annualized rate, unless otherwise specified

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Economics–Markets–StrategyJapan


JAPA

N

JP: Is the party over?

The volatility in Japan’s financial markets has increased notably since 2Q. The Nikkei ended its 6-month long rally, falling sharply by more than 15% during the past three weeks since May 23rd. Some external factors such as concerns over China slowdown and US’s QE tapering triggered risk aversion. Internally, the enthusiasm over Abenomics also seems to be fading.

QE surprises won’t be permanent

The major achievement of Abenomics so far is monetary policy easing. The Bank of Japan announced “quantitative and qualitative easing” in April, pledging to double the size of base money to JPY 270trn in two years. Base money as a percentage of GDP will be boosted to 60% in 2014 from 30% in 2012, far higher than the Fed’s 20% and the ECB’s 28% at present. Meanwhile, the BOJ will lengthen the average duration of its JGB holdings to 7 years from less than 3 years, also catching up with the US Fed (10 years currently). Expectations on BOJ’s QE successfully ignited the financial markets, lifting equity prices, pushing down bond yields and weakening the yen. This QE-driven market rally continued well through Nov12-Apr13.

The announce-ment effects of QE began to fade

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• The enthusiasm over Abenomics seems to be fading, in the lack of new policy excitement (QE and structural reforms)

• Financial market volatility has increased

• But economic data are expected to remain strong, helping to avoid a major reversal in sentiment

• We forecast an above-trend growth of 1.8% this year. GDP growth is projected to slow to 0.9% in 2014

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QE can boost sentiment and move the financial market indicators in the favorable direction in the short term, but the effects can’t last forever. After all, the central bank can’t beat the financial market expectations permanently via innovative QE measures. By expanding aggressively both in terms of the size and the composition of bond asset purchases, the BOJ won’t have many options if they intend to create new surprises in the financial markets in the near future (except for increasing the buying of risky assets such as ETFs and REITs).

As the announcement effects of QE began to fade, investors started to question whether QE can boost the real economic activity in Japan. The BOJ wishes to create inflation expectations and inflation via aggressive easing, so as to encourage consumers to save less and spend more, taking the economy back to a virtuous path of rising prices and rising demand. Inflation expectations amongst Japanese consumers have indeed increased in recent months, as revealed by the consumer confidence survey (Chart 1).

Whether inflation expectations can boost consumer spending and therefore the actual inflation remains a question. The saving ratio amongst Japanese households has been falling persistently and sharply over the past two decades, from more than 10% in early-1990s % to only 2-3% in early-2010s, as a result of rapid population aging (Chart 2). The consumption weakness in Japan was not caused by high savings, but by the stagnancy of income/wage growth.

To be sure, even without a rise in income growth, consumers can increase spending via increasing borrowings. If inflation expectations rise and real interest rates decline, consumers should have stronger incentives to borrow and invest in riskier assets. The problem is higher inflation expectations could also lead to a rise in nominal market interest rates, which will in turn, keep real capital costs from declining.

Indeed, the 10-year JGB yield has already risen 40bps over the past two months. The rise started in the beginning of April, even prior to the recent volatility in global bond markets caused by concerns over the Fed’s QE tapering; which means the rise in JGB yields was driven by Japan’s domestic reasons to a large extent (Chart 3). At the same time when the 10-year JGB yield approached 1.00% in end-May, the Nikkei peaked and started to fall, showing investors’ anxiety over higher bond yields and doubts over the QE’s effectiveness (also Chart 3).

Investors started to question whether QE can boost the real eco-nomic activity

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Structural reforms won’t be easy

There is consensus that the most important element of Abenomics is structural reforms to boost the economy’s long-term growth potential. The outlines of a long-term growth strategy were announced on June 5th. The main points include: 1) boost capital investment by 10% in three years and increase R&D investment to 4% of GDP in five years; 2) set up special economic zones to attract foreign investment and double the FDI stock to JPY 35trn by 2020; 3) promote FTA negotiations and increase the FTA-covered trade to 70% by 2018 from 19% currently; 4) boost the female workforce via providing childcare subsidies and other support measures.

In general, the government aims to lift the economy’s growth potential through boosting all the input factors – labor, capital and productivity. Given Japan’s aging population and a low female labor participation rate, encouraging more women to work will be an effective way to increase labor supply. As the saving rate falls and the current account balance deteriorates, introducing foreign capital will also be a wise strategy to support investment growth. Meanwhile, technology R&D and trade openness can directly boost productivity.

This long-term growth strategy covers a broad range of topics and contains a series of quantitative targets. However, in terms of the measures to achieve these targets, the details were lacking. The growth plan announced on June 5th disappointed investors, as reflected in the continued fall in stock market prices (also Chart 3).

Given the parliamentary upper house election scheduled in July, it is understandable that Abe and his ruling LDP party want to avoid some controversial reform issues ahead of the election. A more sufficient discussion on reforms can be made after July, as chances are high that the LDP will win the election and control both houses of the parliament. Still, there is no guarantee that full-fledged reforms can be pushed through after the election. Some reforms are painful and difficult. For instance, labor market restriction and government inefficiency are the most common factors that hinder investment growth in Japan, according to several international surveys on the ease of doing business. Improving the labor market flexibility calls for easier rules to allow companies to fire full-time employees, which is definitely a controversial issue and is difficult to obtain public support.

Meanwhile, the capabilities for the government to offer fiscal incentives to boost the economy are constrained. As the long-term growth strategy outlined in June

There is no guar-antee that full-fledged reforms will be pushed through after July’s election

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disappointed investors, PM Abe said recently that the government will work on the second batch of growth strategy in autumn this year, which may include tax breaks to encourage companies to increase capital expenditures. How to deliver significant tax reduction and at the same time, stick to the target of fiscal consolidation will be a question. The government still aims to lower the primary fiscal deficit by one half by 2015 and balance the deficit in 2020.

Short-term growth drivers remain intact

While we don’t expect exciting progress on the policy front (both QE and structural reforms), we are still confident that economic data will stay positive in the near term, helping to avoid a major reversal in sentiment. The economy grew an impressive 4.1% QoQ saar in 1Q and the high-frequency indicators remained strong in 2Q. We expect full-year GDP growth of 1.8% this year, above the long-term trend of 1.0%.

The implementation of the government’s JPY 10.3trn supplementary budget has begun in 2Q. New contracts of public works, a leading indicator for public investment, jumped strongly in April-May (Chart 4). Fiscal stimulus effects will remain in place until 2Q next year, when the supplementary budget expires and the 3ppt consumption tax hike takes effects as scheduled (pending a final decision in Sep/Oct this year). Owing to the expectations of higher consumption tax next year, consumers would be motivated to bring forward spending. Private consumption and public spending are expected to be important growth drivers this year (Chart 5).

Meanwhile, our baseline forecast assumes an improvement in global demand in 2H13, which will boost Japan’s exports. A weak yen should also help Japanese exports. Despite the recent correction in the FX market, the year-to-date USD/JPY rate of 95 remains about 20% weaker than last year’s 80. The benefits of yen deprecation so far have been mainly reflected in higher export revenues, rather than in export volumes (Chart 6).

Going forward, higher profits will allow exporters to lower prices in the international markets to compete for new orders. Higher profits can also encourage the export-oriented firms to increase investment and raise wages (Chart 7). These positive effects would appear with a time lag, and will be reflected in economic figures from 2H13. Of course, such boosting impact based on exchange rates adjustments will only be one-off, unless the yen enters a secular downtrend.

Public spending and private con-sumption likely to remain strong

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Net exports (JPYtrn, 05P) 9.0 9.7 12.0 2.1 2.5 2.6 2.6 2.6 3.0Exports -0.1 1.8 5.9 -3.5 -1.8 4.2 8.9 6.3 5.7Imports 5.4 1.2 3.5 0.3 -0.4 0.8 3.9 3.8 3.4

External (nominal)Merch exports (JPY trn) 64 70 76 16 17 18 18 19 19

- % YoY -2.7 9.7 8.5 1.5 5.3 13.0 19.9 13.8 11.1Merch imports (JPY trn) 71 76 80 19 19 19 19 19 20

- % YoY 3.8 7.7 5.2 8.2 6.8 6.4 9.6 1.8 6.1Merch trade balance (JPY trn) -7 -6 -4 -3 -2 -1 -1 -1 -1

Current acct balance (USD bn) 60 65 79 - - - - - -% of GDP 1.0 1.3 1.7 - - - - - -

Foreign reserves (USD bn) 1,268 1,263 1,247 - - - - - -

InflationCPI, % YoY 0 0 2.0 -0.6 -0.3 0.3 0.6 0.8 2.7

OtherNominal GDP (USD bn) 5,961 4,960 4,850 - - - - - -Unemployment rate (%, sa, eop) 4.3 4.1 4.1 4.0 4.1 4.1 4.1 4.1 4.1Fiscal balance (% of GDP) -9.0 -8.0 -6.5 - - - - - -

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Economics–Markets–StrategyEurozone

Radhika Rao • (65) 6878 5282 • [email protected]

EUR

OZO

NE

EZ: No easy way out

As the markets factor risks of a gradual unwinding of the US QE3 asset purchases on the back of an improving jobs market (the veracity of which we question), the ECB is in no such luck. In the Eurozone, GDP growth contracted in 1Q13 and is questioning prospects of 2H13 recovery. Inflation, meanwhile, is well-below the central bank targets and worryingly so. While financial market metrics are not-threatening, one area to watch out for, is the potential rise in the US Treasury yields on the speculation of a Fed QE3/rate move. If this sustains, it might consequently exert upward pressure on the European bond yields, further delaying the recovery process. Such an occurrence, however, might put the unused Outright Monetary Transactions (OMT) to test.

Growth still in a rut, deflation fears lurk

Output in the currency-area contracted 1.0% YoY in 1Q13, though the pace of decline eased on QoQ sa terms to -0.2%, from -0.6% the quarter before. This compares with 0.5% YoY contraction in GDP growth in 2012. Under the hood, there was more evidence of demand destruction brought about by higher taxes, cutback in welfare spending and record unemployment rate. In 2012, on average, domestic demand erased 2.1 percentage points (ppt) off headline growth, even as net exports added 1.7ppt. More of the same is likely this year as the latest jobless rate inched up to record 12.2% sa, just as external trade stays pressured on weak intra/global demand. In light of the prolonged slowdown we revise down our GDP growth to

• GDP growth contracted in 1Q13 and we question optimism on 2H13 recovery; our estimate revised to -0.6% in 2013, hold +0.1% for 2014

• Inflation is well-below the central bank targets and worryingly so

• ECB likely to price in evolving growth and inflation risks, but policy guidance will predominantly be accommodative

• Current account position is on the mend,but it is important to ascertain whether the drivers are sustainable and desirable

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-0.6% for 2013, from -0.3% earlier. For 2014, we maintain our sub-consensus 0.1% estimate. The prolonged economic downturn has also impacted the assessment of the potential output levels, with the European Commission lowering the potential growth rates from 1.8% in 2003-07 to 0.5% in 2009-13. In other words, the output gap will be negative for at least next two years.

The high-frequency indicators are mixed, though data since April have stabilised (still at exceptionally weak levels). Data from the manufacturing sector has been encouraging as the related PMI gauge, whilst still contractionary, has inched up after hitting bottom in Mar13 (see chart). This should reflect in the 2Q13 industrial production numbers, alongside slight tick up in business conditions indices. Notably, when the slight pickup in the currency-wide PMI/ IP is juxtaposed against weakness displayed in the household expenditure trends, the upswing appears to stem from restocking requirements and not real demand. If this indeed is the case, then the anticipated gradual recovery in 2H is likely to be pushed further out.

In midst of the on-going recession, demand destruction and pullback in international energy prices, the down-run in inflationary pressures is not surprising. After averaging 2.5% YoY in 2012, the headline HICP slowed to 1.6% between Jan-May13. Much of this has been due to the 14% drop in Brent prices (in EUR terms) since January, even as the currency lost ground. Again, the weakness in the real economy has raised fears that this de-inflationary trend might persist and pose a fresh policy headache for the central bank. This has also partly fed into the calls for an accommodative rate outlook, to re-inflate demand and prevent slip into a deflationary trap.

An outlying aspect from this economic malaise - longer the economic pain, greater the social damage. There have been sporadic protests in the past few months, though if growth continues to take a hit on draconian fiscal consolidation, the risks of social stress could worsen. High jobless rate, a steep rise in youth unemployment rate to above 35% in few member countries is of particular concern.

This and the need to arrest the downward spiral in growth led the European Commission to provide seven countries more time to hit their budget targets. Spain, France, Poland and Slovenia were given two years extension, while Netherlands, Portugal and Belgium received another one year extension. The easing in the fiscal stranglehold should help the governments scale back on further spending cuts, but this alone is not sustainable to revive growth. The need for structural reforms cannot be downplayed, though impact of these do not pan out in the near-term and thereby have not attracted sufficient favour.

Need to prevent slip into a defla-tionary trap

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Chart 3: PMIs looking better but still in contractionary terrain

50.0 - neutral Latest: May13

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No clear-cut path ahead for the ECB

Broad deterioration in data since beginning of the year and increasing likelihood of a weak 1Q13 GDP performance led the ECB to relent with a 25bp cut in May. Barring a handful of market rates like the emergency liquidity assistance facility that is pegged to the policy rate levels, an impaired transmission mechanism has made it difficult for banks to pass-on the benefit of low short-term rates to the private sector, corporates and consumers. As reflected in the Chart 4, even though the ECB main refinancing rate is at 0.5%, the rates on loans for a year are at 4.76% in Italy, 3.97% in Spain, 7.2% in Greece and 3.1% in Germany. This is assuming no difference in the extent of nation-specific tighter credit controls.

Pressure has remained on the ECB to undertake quantitative easing like the Fed and BOJ to spur growth. However, lack of a unified fiscal set-up in the currency-area restricts the central bank from indulging in a similar program. Apart from the OMT that is intended to keep bond yields from reaching distressed levels, there are two main other alternatives under consideration.

Amongst the foremost is the prospect of introducing negative rate on deposits. Such a move is intended to dis-incentivise banks from keeping funds with the central bank and instead lend out to the real economy. However, this might not be as straight-forward. Apart from the supply of funds, the malfunctioning credit markets have also been a function of weak consumption and investment sectors in the Eurozone. Also notably, such a shift could further hurt banks’ earnings, worsening the impact of the on-going deleveraging process. That said, negative rates could serve to lower the interbank rates and by extension the commercial lending rates. The likelihood of this move is high, though not imminent.

The other policy support being mulled is relaxing the restrictions on the collateral for bank credit. According, there has been talk of reviving the asset-backed securities (ABS) market. While these may help banks to part with their credit risk and raise funds to meet regulatory requirements, pitfalls are notable too. Apart from the notorious reputation that these securities have earned during the US financial crisis, there are concerns that the ECB could be saddled with bad debts and face heightened credit risk by taking up these securities. With the local press reporting Germany’s reluctance to such a plan of action, alongside few other members in the Executive board, these measures could involve more deliberations. Few others that found a mention are LTROs, collateral changes, forward guidance for policy, amongst others.

Lack of a unified fiscal set-up re-stricts ECB room in-dulging in QE style support

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Chart 4: ECB Loan rates - non financial corporates 1yr% pa

Latest: Mar13

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EurozoneEconomics–Markets–Strategy

From -1.8% of GDP in mid-2008, the current account surplus recovered to record +2.5% in 1Q13

Sources for charts and tables are CEIC Data, Bloomberg and DBS Group Research (forecasts are transformations).

In all, the central bank is likely to price in evolving growth and inflation risks, but policy guidance will predominantly be accommodative. One area to watch out for, from this perspective is the impact from a rise in the US Treasury yields on the speculation of a Fed QE3/rate move. This might exert upward pressure on the European bond yields, on which account we expect the unused Outright Monetary Transactions (OMT) to be put to test.

Current account registers some improvement

While the member countries struggled to meet the fiscal and debt targets, at least one of the external balances registered some improvement through the broad deleveraging exercise in the Eurozone. From -1.8% of GDP in mid-2008, the current account surplus recovered to record +2.5% in 1Q13. In nominal terms, 1Q13 notched EUR 55.8bn surplus, up from 2012 quarterly average of EUR +30.1bn and 2011’s EUR -0.4bn. With the current account position now on the mend, it is important to ascertain whether the drivers are sustainable and desirable. Not, on both counts.

As highlighted in the Chart 6, the sharp improvement in the current account dynamics, especially since 2H12 has been a function of wider merchandise trade surplus, while the other components – services, transfers and income remain steady. Digging deeper, the turnaround was driven by both legs of trade, though the imports slowdown was sharper than exports. From 13.7% YoY growth in 2011, exports eased to 5% between Jun12-Mar13. The imports bill in the same period slowed from 14% in 2011 to -1.3%. Not surprisingly and in light of on-going recession in most member countries, the decline in private sector investments, fiscal consolidation efforts and deleveraging in the household balance sheets impinged on import growth.

From a rebalancing perspective, with the exchange rate out of the purview of the national authorities, an improvement in the competitiveness quotient will require a complete pass-through of falling labour costs, which is yet to materialise. Overall, the on-going recessionary phase will also keep a lid on import demand, with slowing public/ private sector savings accompanied by falling investments, thus making the bottom line look better, but at a cost. At the margin, the improved external balance has provided support to the common currency.

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Chart 6: Current acct up on better trd bal

EUR bn, sa

Latest: Mar13

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Chart 5: Current account surpluses on the mend

as % of GDP

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Eurozone Economic Indicators

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%, refi rate

2012 2013f 2014f 1Q13 2Q13f 3Q13f 4Q13f 1Q14f 2Q14fReal output and demandGDP growth (05P) -0.5 -0.6 0.1 -1.1 -0.6 -0.5 -0.2 -0.2 0.0

Private consumption -1.3 -0.8 -0.1 -1.2 -0.8 -0.5 -0.5 0.0 0.0Government consumption -0.4 -0.4 -0.2 -0.6 -0.5 -0.4 -0.2 -0.1 0.0Gross capital formation -4.2 -3.2 -1.0 -5.5 -4.0 -2.5 -2.0 -2.0 -1.4

Net exports (EURbn) 328 346 362 91 85 85 88 95 90Exports (G&S) 2.9 2.4 2.6 0.7 2.3 2.4 2.5 2.6 2.7Imports (G&S) -0.8 1.4 2.0 -1.6 1.2 1.6 2.2 2.0 2.0

Contribution to GDP (pct pts)Domestic final sales (C+FI+G) -2.0 -1.1 -0.3 -1.5 -0.6 -0.4 -0.4 -0.4 -0.3Net exports 1.4 0.6 0.4 0.8 0.3 0.1 0.1 0.2 0.2

External accountsCurrent account (EUR bn) 120.0 140.0 90.0 na na na na na na% of GDP 1.2 1.5 0.9 na na na na na na

InflationHICP (harmonized, % YoY) 2.5 1.5 1.9 1.9 1.3 1.4 1.5 1.7 1.8

OtherNominal GDP (EUR trn) 9.5 9.6 9.8 2.3 2.4 2.3 2.6 2.7 2.7Unemployment rate (%, sa, eop) 11.4 12.4 12.2 12.0 12.2 12.6 12.6 12.2 12.2

* % change, period-on-period, seas adj, annualised unless otherwise specified


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