Economics Markets Strategy - the DBS Vickers Securities Equities ...

Economics
Markets
Strategy
3Q 2008
DBS Group Research
12 June 2008

3Q 2008
Economics – Markets – Strategy
Singapore Sales
Investor Advisory:
Donne Lee Boon Hua (65) 6878 5237
Rina Ooi Cheng Pheng (65) 6878 2088
Sebastian Lee; Cecilia Tan Wee Pin; Ian Gan Guan (65) 6878 6775
Wilson Teo (65) 6878 9755
Regional Structured Product Advisory: (65) 6878 4734/5
Thio Tse Chong, Yip Peck Kwan,
Amiel Gaa; James Tan Kia Huat
Corporate Advisory I: (65) 6878 5367/8
Teo Kang Heng (65) 6223 3383
Rebekah Chay Wan Han (65) 6878 5367
Wesley Foo Shing Meng (65) 6878 5683
Corporate Advisory II: (65) 6878 2090/1
Liang Eng Hwa
Lisa Wong Wei (65) 6224 5433
Regional Equities
Lim Kok Ann (Institutional, DBS Vickers Securities) (65) 6398 7170
Leong Mun Wai (Retail, DBS Vickers Securities) (65) 6398 7688
Hong Kong Sales
Advisory Sales
Leung Tak Lap (852) 3668 5668
Alex Woo Kam Wah (852) 3668 5669
Dick Tan Siu Chak (852) 3668 5680
Liu Tao (852) 3668 5760
DCM Sales
Josephine Tom Chi Ming (852) 3668 5775
Mo Derek Ne-Win (852) 3668 5777
Christine Chong Gan (852) 3668 5774
China Sales
Wayne Hua Ying - Shanghai (86 21) 3896 8609
Steven Huang Yong - Guangzhou (86 20) 3884 8010 ext. 860
Ken Li Guo Qiang - Shenzhen (86 755)8269 0939
Taiwan Sales
Teresa Chen Li Hsiang (886 2) 8758 0563
Jakarta Sales
Dewi Thamrin (62 21) 390 3366 extn 220
PLEASE SEE BACK COVER FOR GENERAL CLIENT CONTACTS
Disclaimer:
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 information 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.

Economics – Markets – Strategy
June 12, 2008
Contents
Economics On a clear day 5
Currencies Slipping on oil & USD 23
Yield Bearish 43
Asian Equity Between the devil and the deep blue sea 56
Greater China, Korea
China Re-thinking CNY appreciation 70
Hong Kong Rates bottom, good for inflation 76
Taiwan Staying on track 82
Korea Surviving 88
Southeast Asia, India
India Rising growth, inflation 94
Indonesia Fingers crossed 100
Malaysia Biting the bullet 108
Thailand Politics over economics 114
Singapore Inflation woes 120
Philippines Back-tracking 126
Vietnam Growing pains 132
G3
United States Forecasts rising 138
Japan What virtuous cycle? 142
Eurozone ECB eyes wages 148
1

June 12, 2008
Economics – Markets – Strategy
Economic forecasts
GDP growth, % YoY
CPI inflation, % YoY
2005 2006 2007 2008f 2009f 2005 2006 2007 2008f 2009f
US 3.2 3.3 2.2 2.0 2.6 3.3 3.2 2.9 3.5 2.3
Japan 1.9 2.4 2.0 1.6 1.6 -0.3 0.2 0.1 1.1 0.6
Eurozone 1.6 2.9 2.6 2.0 2.0 2.2 2.2 2.1 3.0 2.1
Indonesia 5.7 5.5 6.3 6.0 6.3 10.5 13.3 6.3 10.3 7.2
Malaysia 5.0 5.9 6.3 5.1 5.8 3.1 3.6 2.0 4.5 3.3
Philippines 4.9 5.4 7.3 5.4 6.0 7.7 6.3 2.8 9.0 4.8
Singapore 7.3 8.2 7.7 6.0 6.8 0.5 1.0 2.1 6.4 2.8
Thailand 4.5 5.1 4.8 5.0 4.7 4.5 4.6 2.2 6.4 2.8
Vietnam 8.4 8.2 8.5 6.4 6.9 8.3 7.5 8.3 26.3 15.0
China 10.4 11.1 11.9 10.0 9.0 1.8 1.5 4.8 6.5 4.5
Hong Kong 7.1 7.0 6.4 5.2 4.7 1.0 2.0 2.0 5.0 4.0
Taiwan 4.2 4.9 5.7 5.0 5.4 2.3 0.6 1.8 3.4 2.4
Korea 4.2 5.1 5.0 4.6 5.0 2.8 2.2 2.5 4.6 3.0
India* 9.2 9.7 9.0 8.6 8.6 4.4 5.4 4.3 6.8 4.9
* India data & forecasts refer to fiscal years beginning April; inflation is WPI
Source: CEIC and DBS Research
Policy and exchange rate forecasts
Policy interest rates, eop
Exchange rates, eop
current 3Q08 4Q08 1Q09 2Q09 current 3Q08 4Q08 1Q09 2Q09
US 2.00 2.00 2.50 3.25 4.00 … … … … …
Japan 0.50 0.50 0.50 0.75 0.75 107.6 107 108 109 110
Eurozone 4.00 4.25 4.25 4.25 4.25 1.540 1.52 1.49 1.46 1.43
Indonesia 8.50 9.25 9.25 9.25 9.25 9,325 9,500 9,600 9,700 9,800
Malaysia 3.50 4.00 4.00 4.00 4.00 3.28 3.30 3.35 3.40 3.45
Philippines 5.25 5.75 6.00 6.00 6.00 44.4 45.0 47.0 45.0 45.0
Singapore n.a. n.a. n.a. n.a. n.a. 1.38 1.38 1.40 1.42 1.44
Thailand 3.25 3.25 3.75 3.75 3.75 33.2 33.5 34.0 34.5 34.9
Vietnam^ 14.00 15.00 16.00 16.00 14.00 16,621 16,740 16,860 16,990 17,120
China* 7.47 7.47 7.74 8.01 8.28 6.91 6.80 6.75 6.70 6.65
Hong Kong n.a. n.a. n.a. n.a. n.a. 7.81 7.83 7.85 7.85 7.85
Taiwan 3.50 3.75 3.88 3.88 3.88 30.5 30.5 31.0 31.5 32.0
Korea 5.00 5.00 4.75 4.50 4.50 1034 1075 1100 1075 1075
India 8.00 8.25 8.25 8.25 8.25 42.8 43.0 43.5 42.5 42.5
^ prime rate; * 1-yr lending rate
Source: Bloomberg and DBS Research
2

Economics – Markets – Strategy
June 12, 2008
Interest Rate Forecasts
%, eop, govt bond yield for 2Y and 10Y, spread in bps
11-Jun-08 3Q08 4Q08 1Q09 2Q09
US 3m Libor 2.79 2.60 3.00 3.65 4.30
2Y 2.81 3.59 4.00 4.42 4.66
10Y 4.07 4.60 5.00 5.30 5.40
10Y-2Y 127 101 100 88 74
Japan 3m Tibor 0.84 0.75 0.75 1.00 1.00
Eurozone 3m Euribor 4.96 5.05 4.85 4.65 4.50
Indonesia 3m Jibor 8.98 9.40 9.40 9.40 9.40
2Y 12.62 11.00 10.50 10.00 10.00
10Y 13.50 12.50 12.00 11.50 11.50
10Y-2Y 88 150 150 150 150
Malaysia 3m Klibor 3.66 4.15 4.15 4.15 4.15
3Y 4.04 4.40 4.20 4.00 4.00
10Y 4.46 4.80 4.70 4.60 4.60
10Y-3Y 42 40 50 60 60
Philippines 3m Phibor 6.75 6.75 7.00 6.75 6.75
2Y 8.35 8.50 8.75 8.75 8.75
10Y 9.48 9.50 9.75 9.75 9.75
10Y-2Y 114 100 100 100 100
Singapore 3m Sibor 1.44 1.31 1.52 1.94 2.31
2Y 1.27 1.60 2.20 2.40 2.65
10Y 3.61 3.80 3.90 3.93 4.04
10Y-2Y 234 220 170 153 139
Thailand 3m Bibor 3.50 3.45 3.95 3.95 3.95
2Y 4.66 4.70 4.80 4.90 4.90
10Y 5.66 5.90 6.00 6.10 6.10
10Y-2Y 100 120 120 120 120
China 1 yr Lending rate 7.47 7.74 8.01 8.28 8.28
2Y 3.72 4.00 4.25 4.25 4.25
10Y 4.27 4.40 4.50 4.50 4.50
10Y-2Y 55 40 25 25 25
Hong Kong 3m Hibor 2.15 1.95 2.35 3.05 3.70
2Y 2.66 3.02 3.69 3.87 4.08
10Y 3.59 4.05 4.45 4.75 4.85
10Y-2Y 93 103 76 88 77
Taiwan 3m Repo 2.65 2.75 2.88 2.88 2.88
2Y 2.31 2.25 2.50 2.50 2.50
10Y 2.72 2.80 2.90 2.90 3.00
10Y-2Y 42 55 40 40 50
Korea 3m CD rate 5.36 5.20 4.95 4.70 4.70
2Y 5.73 5.60 5.00 4.90 4.90
10Y 5.94 5.80 5.30 5.30 5.30
10Y-2Y 21 20 30 40 40
India 3m Mibor 8.91 7.80 7.80 7.80 7.80
2Y 8.10 8.40 8.40 8.40 8.40
10Y 8.26 8.50 8.50 8.50 8.50
10Y-2Y 16 10 10 10 10
Source: Bloomberg and DBS Research
3

Economics
Economics – Markets – Strategy
This page is intentionally left blank
4

Economics – Markets – Strategy
Economics
On a clear day
• US demand growth has dropped to zero over a three year period. Oil
prices have tripled over the same time frame. Disaster planners could
not have invented a more testing scenario
• Yet growth in Asia remains stronger than it should be even on a clear
day
• Demand, mostly Asian, explains both puzzles. Asian demand kept
growth alive and demand ‘survived’ the rise in oil prices because it
drove the rise in oil prices
• Oil prices are driving inflation in the US and Europe. But data clearly
show that the price of oil is no longer made in America or in Europe.
It is made in Asia
• G3 central banks may have to accept an inflation rate made in Asia too.
That, or a permanently lower growth rate
On a clear day, “Asia” ought to grow by about 7% per year. Some countries
grow faster of course (the young turks like China and India), some slower (the
graduates of the early stages of development like Singapore, Hong Kong, Taiwan
and Korea) and some in between, like Thailand, Indonesia and Malaysia. Put
them all together though and in simple average terms – better than weighted
average terms for many purposes – you’re talking about a 7% growth rate. On
a clear day.
But the skies haven’t been so great lately. In fact, Asia has collided head-on into
what most have for a long time considered to be its two greatest threats to
growth: a US on the brink of recession, or so it is said, and indisputably record
high oil prices in real and nominal terms.
World's largest oil importers and consumers
mn bbls / year, 2006
Country
Imports (net)
World
rank
Consumption
World
rank
US 4,510 1 7,551 1
Japan 1,836 2 1,883 3
x China 1,225 3 2,628 2
Germany 918 4 973 5
x Korea 787 5 794 9
France 690 6 716 12
x India 627 7 939 6
Italy 572 8 632 14
Spain 570 9 581 16
x Taiwan 343 10 347 19
Netherlands 341 11 369 18
x Singapore 301 12 305 22
Turkey 228 13 244 23
x Thailand 217 14 339 20
Source: US EIA: http://tonto.eia.doe.gov
Nomenclature
References to Asia in
this report adhere to
the follow conventions:
Asia 10: CH, HK, TW,
KR, SG, MY, ID, TH,
PH, IN
Asia 9: Asia 10 less IN
Asia 8: Asia 10 less IN
and CH
Asia Hi-tech5 (HT5):
KR, TW, SG, MY, TH
Asean 5: SG, MY, TH,
ID, PH
Asean 4: Asean 5 less
SG
Eurozone: EU12
G4: Asia10, US, JP, EZ
ECONOMICS
David Carbon • (65) 6878 9548 • davidcarbon@dbs.com
5

Economics
Economics – Markets – Strategy
Oil prices are at all
time highs no
matter what
currency you
measure them in
Take them one at a time. The US is indeed growing far more slowly than normal.
That’s not new, as we frequently point out, but it is serious. GDP growth has
been falling steadily for four years. And while it is still positive, American
demand growth – far more important to Asia than GDP growth per se – has not
grown one iota for the past two quarters. Ten or twenty years ago, Asia might
be flat on its back by now. So little wonder that everyone thinks the skies are so
dark.
Then there’s oil. In US dollar terms, prices have doubled in the last 15 months
and tripled since Jan05. They are now at record highs in nominal terms and real
(inflation-adjusted) terms. This is not just a “weak dollar effect” so stronger
local currencies aren’t going to solve the problem. Crude prices are at all-time
highs measured in dollars, euros (/ECUs), deutschemarks, francs, pounds or any
Asian currency unit. Of 20 key currencies in which we have priced oil in real
terms, only in yen and Italian lira terms are real crude prices not quite back to
Nov79 levels (the previous peak in real terms). But they are not far off the mark
either.
G3 (US, EZ, JP) real and nominal crude oil price
Jun08=100, wtd avg spot price in local ccy terms, real deflated by country-specific CPIs
100
Nov79:
86
Jun08:
100
80
60
Feb74:
56
real
wt avg price
40
Oct90:
40
20
0
nominal
wt avg price
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
Asia is home to 6 of
the world’s 14
largest oil
importers
High prices are a burden for importers of oil and Asia is home to 6 of the world’s
14 largest (Table 1, p1). China is the world’s third largest net importer; Korea
ranks fifth, India 7th, Taiwan 10th and Singapore 12th. Thailand is the world’s
14th largest but, as a percentage of GDP (8%), it is Asia’s largest and most precariously
placed given the run-up in prices. A doubling of oil prices would, in many a
‘first principles’ calculation, cost the country eight percentage points of GDP.
That would be a crippling blow for Thailand and for many other Asian countries,
even with smaller oil deficits. And in an old-fashioned oil crisis, like the ones in
1973-74 and 1979-80, the cost of such an price spike might just be that great.
Thus, either of these obstacles – zero US demand growth or a doubling / tripling
of oil prices – are by themselves enough to make investors squirm and government
officials tremble. But put the two together and you’re talking about something
altogether different. It’s the disaster scenario. Nothing more, nothing less.
And it isn’t a hypothetical ‘what if?’. Asia is right in the middle of it. Right
here, right now.
6

Economics – Markets – Strategy
Economics
And yet, something is going right. Asia is in the middle of the disaster scenario
and nothing is turning out disastrous. On the contrary, growth is stronger than
it should be even on a clear day.
Singapore reported 6.7% YoY growth in the first quarter. That’s one-third faster
than what the government reckons to be potential. And it’s faster than it was
three years ago, when US growth was 4% YoY (chart below) and oil prices were
one-third what they are today. Talk about bucking headwinds.
But Hong Kong did even better. It reported 7.1% growth in the first quarter
when 4.5% is normal for a clear day. China grew by 10.6%, probably above it’s
potential rate, India by nearly 9%. Korea and Taiwan grew by about 6%, well
above potential for economies of their income and technological levels. And
Malaysia grew by 7.1% YoY! That’s faster than at any time in the last three
years save for 4Q07 when it grew by 7.3%. Likewise for Thailand, which grew
by 6.1%, its fastest rate in two years and nearly its fastest in three.
Asia is in the middle
of the disaster
scenario and
nothing is turning
out disastrous
Income and demand growth – Asia & US
% YoY, 2qma, simple average
8
7
6
5
4
3
Asia 10
GDP
Asia 8
GDP
(ex-CH, IN)
7%
6.3%
2
1
US
domestic demand
1.5%
1.6%
0
Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07
What’s really interesting is that the skies didn’t darken just last night. The US
has slowed – steadily and extensively – over the past 3.5 years (chart above). Oil
prices are 3 times higher than they were three years ago. And economic growth
in Asia is either still running above potential and/or, in the cases of Thailand
and Malaysia, faster than at any time in the last 2-3 years.
That isn’t impressive. It’s surreal. The environment is hell, the outcome sublime.
What is Asia doing right? How can Asia be growing so well when US demand
growth is zero and oil prices have tripled?
The answer to both questions, we think, is demand. Asian demand mostly.
Asian demand is driving Asian growth in the absence of the US. And Asian
demand is key to the growth in global petroleum demand that appears to be
mainly responsible for today’s higher oil prices.
What explains the
puzzle? Demand
growth, mostly
Asian
7

Economics
Economics – Markets – Strategy
Asia’s role in oil and aggregate demand represents a big change from the past.
The US has long been the key driver of global growth but, as we have argued
for the past 3 years, this role is rapidly being passed over to Asia. Asia is providing
more and more of the world’s incremental demand growth each year and that,
by definition, is what drives global growth.
Asia is now the
single largest driver
of global oil
demand growth
With respect specifically to oil, there are two points to make. First, Asia’s demand
is now the single biggest driver of global oil demand and second, it is increasingly
apparent that the run-up in prices over the past five years is a function mainly
of demand growth and not supply constraints. The persistent rise in oil prices
running hand-in-hand with an equally persistent rise in global output (chart
below) point plainly and compellingly to demand as the culprit behind higher
prices, not supply.
G4 – industrial production and crude oil price, 2002-2008
Jan02=100, sa
123
wt avg G4 ccy unit / bbl, Jan02=100, Brent crude
600
118
113
108
103
IP
(LHS)
Oil price
(RHS)
500
400
300
200
100
98
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
0
Output and oil
prices rising in
tandem points
plainly to demand
growth as the
driver of higher
prices
There are many implications from this but one important one is that any estimate
of the “cost to growth of higher oil prices” that is based on the experience of
past oil crises – when sharp supply contractions led to higher prices and contractions
in output – are bound to be far off the mark. Higher oil prices are always a
burden on growth but one that is qualitatively different when prices are driven
upward by an expansion in demand as opposed to a contraction in supply. When
driven by demand, the cost of higher oil is paid in real time, as you go. When
driven by a pullback in supply, a hammer is lifted that soon falls. When it does,
the growth cost is more visible, more measurable and very decidedly after-thefact.
Times change. We are used to thinking of higher oil prices in terms of supply
shocks and falling output. And we are used to thinking of the US as The Driver
of global growth. But these lines of thought are outdated.
Demand – mostly Asian – explains why growth in the region has survived a
three year slowdown in the US and a tripling in oil prices. It explains why, in
the middle of the worst disaster planning scenario, there’s no disaster. Growth
is better than on a clear day. This is worth a closer look.
8

Economics – Markets – Strategy
Economics
Asian final demand as the driver of global growth
This is key ground but it’s old ground for us so we’ll be brief. Readers looking
for more detail are referred to a number of previous reports (1). The US slowdown
is very old news. It started four years ago (see chart, p7). Worries of such have
led to countless forecasts along the lines of: “for every percentage point drop in
US growth, Asian growth is likely to drop by X percentage points”, where X was
typically 2. All those exports from Asia running into China? They were merely
being flipped around to the US, most said. All the final demand, it was said,
was coming from the US. When that dried up, so too would Asia’s exports into
China (and vice-versa).
But starting in late-2004, the US began to slow (2). By late-05, growth had fallen
by a full percentage point. Had Asian growth fallen by 2 percentage points?
No. On the contrary, it had accelerated by a percentage point. Give it time,
most said, give it time. But a year later and growth paths had diverged further.
A year after that, further yet. After a full three years, US demand growth had
fallen to a measly 1.5% YoY and Asia was still accelerating. This had never in
history happened before.
What happened? And why were the “two-fer-one” estimates so far off the
mark? The estimates were wrong because they were made using data from a
long time ago. A long time ago, US demand really did drive Asian supply and
two-fer rules came pretty close to the mark. A long time ago, Asian demand
was too small to drive it’s own growth, let alone global growth.
But – and this is the biggest but in the last twenty years – Asia is no longer too
small to matter. It has grown by 50% in the last five years alone. It’s still a lot
smaller than the US (the relative sizes of domestic demand are about 100:40)
but when you put an Asian growth rate – 7% on a clear day – on top of that 40
cent base, what you find is that Asia generates almost as much new demand
each year in dollar terms (or yen or yuan terms) as the US does. And it’s those
dollars of new demand that, by definition, drive global growth.
How much final / domestic demand Asia generates each year relative to the US
is shown in the picture below. Hopefully this picture is familiar by now. Because
we continue to believe that if there is one single picture to bear in mind when
one thinks about where Asia over the next 4-5 years, this is it. The picture is
simple – one straight line, no intersections, no circles, no dips, no doos. No
nonsense.
Asia accelerated
for three years
while the US
slowed. Never
before in history
did this happen
The reason is
simple: Asia is no
longer too small to
matter
Asia 10 – incremental domestic demand growth converges on the US
Incremental Asian DD growth as % of same in US, structural terms
100
90
93 cents
80
70
60
50
In 2008 for every
dollar of fresh
demand the US puts
on the global table,
Asia will put out 93
cents
40
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
9

Economics
Economics – Markets – Strategy
The rise in Asian
demand is a
structural one. It is
not going to go
away anytime soon
And the numbers are compelling. Take the data point for this year, 2008, which
reads 93 cents. That says that for every dollar of domestic demand generated by
the US, Asia will generate 93 cents of the same. What’s the arithmetic? Simple.
Assume that US domestic demand is 1 dollar in size. It grows by 3% on a clear
day, thus generating 3 cents of new demand. Now turn to Asia. If the US is 1
dollar in size, Asia’s is 40 cents in size. On a clear day, it grows by 7%, generating
2.8 cents of fresh demand. That’s 2.8 cents for every 3 cents from the US, or 93
cents on the dollar.
What is key is how this ratio has changed over time. Back in 1990, the US
generated more than twice as much new demand each year as Asia did. No
wonder Asia went up and down whenever the US did. No wonder everybody
said, when the US sneezes, Asia catches a cold. No wonder all those two-fer
rules came about. All those rules, all those sayings were pretty much on the
mark. Twenty years ago.
Today, the US no longer generates twice as much demand each year as Asia.
Today it generates 7% more. And that’s on a clear day. On a bad day, like today,
Asia already generates more demand than the US does (American demand growth
has been zero for the past two quarters). But we haven’t shown the sick days in
this chart because we want to stress that this change is a structural one – it has
been occurring for the past 20 years and will continue for the next 20.
Bottom line? It is this structural change, more than anything else, that explains
how Asia managed to accelerate for three years while the US slowed. Asia is no
longer too small to matter. Asian demand is driving Asia’s growth more than
ever before and will, in another year or two, be a bigger driver of global growth
than the US. Plainly, it is the growth in Asia’s aggregate demand that underlies
its growth in demand for oil, to which we now turn.
Higher oil prices – demand-driven
Take a look at the differences in the two charts below. Both plot the global
supply of crude oil (in red, quantity terms) against the price (in grey, measured
in avg USD, EUR/ECU and JPY terms, adjusted for inflation). The picture on the
left shows supply and price during the second oil crisis of 1979-84. Global
supply falls by 15% thanks a drop in OPEC output of 55% between 1979 and
1983. The price of oil triples in 13 months.
Contrast that with the picture on the right – which shows oil supply and price
over the past six years. Oil output expands steadily as the price triples over a
four year period of time (annual average figures).
Global oil production and price – 1979-84
bil bbls/yr avg USD, EUR, JPY terms, CPI def, 79=100
25
225
Global oil production and price – 2000-08
bil bbls/yr avg USD, EUR, JPY terms, CPI def, 98=100
32
300
24
23
real G3
ccy
price
(RHS)
200
175
150
31
30
29
supply
(LHS)
250
200
22
21
supply (LHS)
125
100
28
27
real G3 avg
crude price
(RHS)
150
100
20
77 78 79 80 81 82 83 84
75
26
00 01 02 03 04 05 06 07 08
50
10

Economics – Markets – Strategy
Economics
What’s the difference in terms of economics? Any textbook would say that the
first picture, 1979-84, is one of prices being driven by a contraction in supply.
And it would say that the other picture, from 2002 to 2008, shows prices being
driven north by an expansion in demand.
And what would one expect for the direction of industrial output in these two
situations? That a contraction in oil supply would bring a sharp contraction in
industrial output along with the surge in prices. Plainly, that’s what happened
in the oil crises of 1973-75 and 1979-83. In 1973, oil prices rose by a factor of
nearly four in six months and G3 industrial output dropped by 12% in very
short order. In some countries, like Japan, industrial production fell by 20%. In
the second oil crisis, prices tripled in the 12 months ending Nov79 and were
subsequently maintained there for the next three years. G3 industrial production
fell for three years, by a total of 8%.
G3 – industrial production and crude oil, 1973-75
Nov73=100, sa
wt avg ccy unit/bbl, Nov73=100, Brent
G3 – industrial production and crude oil , 1979-84
Jan80=100, sa
avg ccy unit/bbl, Jan78=100, Brent
100
98
96
Oil
price
(RHS)
400
350
300
102
100
98
Oil
price
300
275
250
225
94
92
90
88
IP
(LHS)
250
200
150
100
96
94
92
Oil
price
triples
in one
year
IP falls
10%
over 3
years
IP
(LHS)
200
175
150
125
100
86
Jan-72 Jan-73 Jan-74 Jan-75 Jan-76 Jan-77
50
90
Jan-78 Jan-80 Jan-82 Jan-84
75
By contrast, when higher oil prices are driven by demand, one would expect to
see a more gradual rise in price along side an uninterrupted rise in output –
precisely the picture seen in the global economy since it last hit bottom in
Dec01. One such picture (for the G4 overall) was shown on page 8. Two additional
pictures of Asia – with and without China/India – are shown below.
Asia 10 – industrial production and crude price
Jan02=100, sa
wt avg ccy price, Jan02=100, Brent
Asia 8 – industrial production and crude price
Jan02=100, sa
wt avg ccy price, Jan02=100, Brent
200
600
180
600
175
150
IP
(LHS)
500
400
160
140
IP
(LHS)
500
400
300
300
125
100
Oil
price
(RHS)
200
100
120
100
Oil
price
(RHS)
200
100
75
02 03 04 05 06 07 08 09
0
80
02 03 04 05 06 07 08 09
0
11

Economics
Economics – Markets – Strategy
Finally, consider Asia’s external balances. If oil prices are being driven north by
global demand growth and rising trade flows, one would expect the earnings
of the oil exporting countries to be recycled through the system (in the form of
greater imports) more readily than when oil and other trade flows are being
constrained. The hit to oil-importing countries’ current account balances should
be much less than what the run-up in oil prices would suggest in isolation. That
too, is what we find in Asia today.
As a percentage of
GDP, Thailand is
Asia’s bigger
importer of oil
Since 2000, the run-up in oil prices has raised the oil deficit in most Asian countries
by 2-4 percentage points of GDP. Thailand’s deficit widened to 8% of GDP in
2007 from 4%, Taiwan’s widened to 5.3% of GDP from about 2%. Indonesia’s
balance swung from a surplus of 1% of GDP to a deficit of 2.2%. Only Singapore
managed to cut its oil deficit on this time frame.
Asia – net oil imports as % of GDP
% of GDP, excluding natural gas
8
6
4
2
7.9
7.4
5.9
5.3
5.1
4.1
2.5
2.2
1.5
2007
2000
0
-2
-1.4
-2.1
-4
TH KR PH TW HK IN CH ID SG VN MY
But Asia’s current account balances have not worsened on this time frame, even
excluding China, whose surplus ballooned to 11% of GDP in 2008 from 1% in
2001. On the contrary, they have risen substantially further into the black. For
the Asia 8 (excluding Malaysia because it is an oil exporter) current account
surpluses rose by an average of 3.2 percentage of GDP between 2001 and 2007 in
Asia ex-China – oil and current acct balance
% of GDP, ex-Malaysia (oil exporter)
9
8
7
6
5
4
3
2
1
net oil imports
current
account
surplus
00 01 02 03 04 05 06 07 08
Asean – oil balance and current acct balance
% of GDP, ex-Malaysia (oil exporter)
11
10
9
8
7
6
5
4
3
2
1
net oil imports
current
account
surplus
00 01 02 03 04 05 06 07 08
12

Economics – Markets – Strategy
Economics
spite of oil deficits that have widened by 2.1 points, on average. (see charts above
and Appendix 1 for individual country data).
Part of the reason for this is surely due to the fact oil exporters are raising their
imports almost as fast as their export go up. They are not simply stashing their
export revenues in Treasuries. Although current account data is not available (or up
to date) for all large oil exporters, is available for many, including 6 of the world’s 7
largest: Saudi Arabia, Russia, UAE, Norway, Kuwait and Venezuela. These countries
have experienced large increases in the value of their petroleum exports. Net oil
exports of this group (plus Mexico, ranked 10th in the world) rose to USD1000bn in
2006 from about USD300bn per year in 2001-02. But their current account surpluses
have risen by far less (chart below left). They have spent the lion’s share of their
increased export revenues on increased imports (chart below right).
There are three implications of all this. First, the current accounts on both sides of
the oil trade support the view that it is demand growth, not supply contraction that
is driving the rise in oil prices. Trade flows remain strong. Current accounts balances
remain surprisingly strong among the oil-importing countries and surprisingly soft
among the oil-exporting countries.
Key petroleum exporters – external balances
US$ bn/ year, SArab, Rus, UAE, Nway, Kwt, Vnz, Mex
900
800
700
600
500
400
300
200
100
0
Net oil
exports
Current
account
surplus
98 99 00 01 02 03 04 05 06 07
Key petroleum exporters – external balances
US$ bn/ year, SArab, Rus, UAE, Nway, Kwt, Vnz, Mex
900
800
700
600
500
400
300
200
100
0
oil exports
(net)
Ex-oil imports
(net, implied by
current account)
98 99 00 01 02 03 04 05 06 07
Second, the cost to importing countries of higher oil prices is surely far lower
than any back-of-the-envelope calculations based on oil deficits as a percentage
of GDP would suggest. When oil exporters spend their increased earnings almost
as fast as they come through the door – unlike during the 1970s – and oil importing
countries external balances get blacker instead of redder, it seems likely that
dynamic gains are outweighing any losses from a higher oil price. Put differently,
a higher oil price may be a step backward. But when it is generated by two
forward steps of demand growth, the cost is already in the price. It is not
lurking up ahead, as when surging prices are generated by a pullback in supply.
Third, all this makes it plain that analysts should be careful about projecting a
deterioration in Asia’s current account balances any time soon. Ditto for currency
traders. A look at Asia’s data over the past six years is probably worth the
minute or two it takes.
13

Economics
Economics – Markets – Strategy
Asian oil demand drives global oil demand
Over the past five years, global oil consumption has grown by about 1.9% per
year. That’s significantly faster than the 1.5% growth averaged between 1985
and 2002. Where has the extra demand come from?
Demand from the
US, Japan and
Europe has fallen
for three years.
Demand from Asia,
mostly China and
India, has more
than made up for it
Not the US. Or at least not much. Demand there is about 5% higher than in
2001 but that was a recession year. On a clear day, US oil demand continues to
grow by about 3/4% per year.
Neither from Japan. Demand there is 4% less than it was in 2001. Nor from
Europe. Demand in Germany, France and Italy is down 4% since 2001 too. It
has been falling in all four countries by about 1% per year since 1996 (charts
below).
So where has the new demand come from? Asia, mostly. Since 2001, Asia’s oil
consumption has grown by some 1.3 trillion barrels, or 48% of the worldwide
total (table next page). China and India account for about 60% of the growth
in Asia.
But a lot of smaller Asian countries have contributed to global consumption
growth too. After China and India, Thailand is key with a 3% contribution to
the total. Indonesia’s oil consumption growth (3% per year) turned that country
from a net exporter into a net importer in 2003. Demand growth there accounted
for another 2% of the global rise between 2001-2006. Singapore, Vietnam,
Taiwan and Korea all contributed significantly. Given their size, this means
they are all punching far outside their weight (table at side).
These numbers are big but they are averages over a five year period, which
obscures much of the trend. By 2006, China and India were accounting for
nearly 2/3rds of the global increase in petrol consumption. Other Asian countries
had cut their consumption modestly but Asia’s contribution to the global total
had still grown to 60% (see Appendix A2).
Asia is driving the growth in global oil demand. But the real story may be this:
Asia’s consumption now (2006) accounts for 20% of the global total. And when
you put its high growth rate (8% for China and 5% for Asia overall) in consumption
demand on that bigger base, it starts to make a big difference to global totals
very quickly.
The bottom line is this: either Asia’s oil demand growth slows significantly or
global demand growth accelerates even more than it already has over the past
five years. Whether production / supply could keep up with that acceleration in
Global petroleum consumption
bbls/ year, 2001=100
140
135
130
125
120
115
110
105
100
95
90
01 02 03 04 05 06
CH, IN: 140
Asia 9: 111
US:
JP, EZ: 96
Global petroleum consumption
bbls/ year, 1992=100
210
200
190
180
170
160
150
140
130
120
110
100
90
80
92 94 96 98 00 02 04 06
CH:
206
Asia ex-
CH, IN:
168
US:
120
JP, EZ:
94
14

Economics – Markets – Strategy
Economics
demand is questionable. And if it cannot, we all
know where prices are headed.
At this point, we would like nothing more than to
be able to say, “You know what? All this oil being
consumed in Asia? It isn’t really being consumed
in Asia. It’s really being consumed in the US. All
that oil is simply going into the production of goods
in China and elsewhere that are then exported to
the US. The final demand is in the US and when it
slows, Asia’s (intermediate) demand for oil will slow
too.”
The thing is, US demand has slowed. For three
years now. But oil demand, and oil prices, have
been going up for five. So no dice. It’s not about
final demand coming from the US or the G3. It’s
about final domestic demand coming from right
here in Asia. Go back to the chart at the bottom
of page 9, the one we said is the single most important
picture to bear in mind when you think about Asia
over the next 4-5 years. It shows where the final
demand is coming from. It shows that Asia’s final
demand growth has almost surpassed that of the
US and very soon will. That picture of aggregate
final demand says oil demand is not mainly about
the US any more, directly or otherwise. It’s about
Asia. This is where the demand is.
If you’re still not sure, consider the picture below.
It shows motor vehicle population per 100 people
in Asia and the G3. Nobody who’s ever been to
Taiwan will be surprised to see it has the highest
density of motor vehicles. I swear it still has more
Drivers of global petroleum demand
2001-2006
(2)-(1) chg as avg
(1) (2) (3) % of growth
Cons Cons Change global rate
2001 2006 06-01 total '01-'06
mn bbls mn bbls mn bbls (%) (%)
World 28,251 30,887 2,636
China 1,795 2,628 833 32 8
US 7,172 7,551 379 14 1
SArab 586 781 195 7 6
India 797 939 142 5 3
Thai 256 339 83 3 6
Russ 945 1,026 81 3 2
Can 751 826 76 3 2
Indon 393 445 52 2 3
Spore 258 305 46 2 3
Viet 65 100 35 1 9
UK 637 668 32 1 1
Twan 322 347 25 1 2
HK 90 107 17 1 4
Korea 778 793 15 1 0
Malay 173 183 9 0 1
Brazil 805 809 4 0 0
Phil 127 124 -3 0 0
France 749 716 -33 -1 -1
Italy 670 632 -38 -1 -1
Germany 1,027 973 -55 -2 -1
Japan 1,969 1,883 -86 -3 -1
Asia 11 5,054 6,310 1,255 48 5
CH+IN 2,592 3,567 975 37 7
GE, FR, IT 2,447 2,321 -126 -5 -1
motorcycles per person than Vietnam (data is unavailable). The US comes in
second place – the auto there being more sacred than Mom and / or Apple Pie
(although, surprisingly, if one looked at auto population alone, German per
capital ownership is higher than in the US). But look who’s at the bottom of the
list. China, with a current density one-20th that of Taiwan and the world’s
fastest per-capita growth rate of some 9.5% per year. Still think oil demand
growth in Asia isn’t going to accelerate over the next 10 years?
Motor vehicle population density, 2007
motor vehicles per 100 people
100
90
80
70
60
50
40
30
20
10
0
90
81
63 62 62
39
34
21
19
9 9
6 5
TW US MY JP GE TH KR ID SG IN HK PH CH
15

Economics
Economics – Markets – Strategy
Cutting the fat
If oil demand is going up from here and prices have already quintupled since
2002, it’s a good thing that countries are growing more efficient with their oil
use. Developed countries like the US, Japan and Germany have cut their oil
consumption, per unit of real GDP, nearly in half since 1980. Some of these
gains are technological (more efficient factories, for example) while some of
the gains are structural (fewer factories and more services).
China has made
Asia’s greatest
strides in raising oil
efficiency
Global petroleum efficiency
bbls consumed per unit of real GDP, 1980=100
100
95
90
85
80
75
70
65
60
55
50
80 82 84 86 88 90 92 94 96 98 00 02 04 06
Asia10: 70
JP: 60
US: 55
GE: 52
In spite of Asia taking on the role as factory for the world, significant efficiency
gains have been experienced here too. On average, Asian countries have cut oil
consumption (per unit of real GDP) by about 30% since 2001. As one would
expect, experience has varied widely.
Asian countries
have cut oil
consumption per
unit of real GDP by
about 30% since
2001
Global petroleum efficiency
bbls consumed per unit of real GDP, 1994=100
110
105
100
95
Japan
90
India
85
80
US
75
China Germany
70
93 94 95 96 97 98 99 00 01 02 03 04 05 06
16

Economics – Markets – Strategy
Economics
China has cut its oil consumption by two-thirds since 1980. That’s Asia’s greatest
efficiency gain but it surely says as much (or more) about how inefficient China
was in 1980 as it does about how efficient China may be today. Still, gains are
gains and a 65% improvement is a big move in the right direction.
If anything, India highlights the point about China. It was no more developed
than China in 1980 and has made relatively fewer gains. India has picked up the
pace more recently, however, and since 1994, average gains in China, India, the
US, Japan and Germany have all been similar and sizable (chart immediately
above).
Elsewhere in Asia experience has been mixed. Korea, Malaysia and the Philippines
have made great strides in cutting oil consumption. Korea in particular stands
out over the past 15 years (chart below). Most are aware that it has imported
huge amounts of technology from Japan and the US over the past three decades
and it certainly shows up in its efficiency gains since 1994. But the Philippines
and Malaysia – far down the technological ladder – have made strides nearly as
great as Korea’s. This may show that the bang for the buck is higher further
down the ladder where the ‘easier’ gains are often said to lie.
Still, Indonesia and Thailand show there is nothing automatic or easy about
productivity growth and efficiency gains. Gains there have been negative, on
average, since 1994. Singapore’s gains have been modest and could reinforce
the idea that the closer one is to the top, the harder it is to take the next step.
Thailand and Indonesia have their work cut out for them. They are among the
world’s largest consumers and importers of oil and stand to lose the most from
higher oil prices (or gain the least from the growth in global demand that
appears to be driving those prices) in the future. The dearth of efficiency gains
there since 1994 surely helps explains why GDP growth in both countries remains
sub-par even ten years after the Asian financial crisis.
But efficiency gains remain as important to the rest of Asia as they do to Thailand
and Indonesia. They have helped most Asian economies lower the price of oil
in real terms and get the most out the growth in global demand since 2001.
Plainly such gains are no less beneficial or important going forward.
Petroleum efficiency improvements since 1994
bbls consumed per unit of real GDP, 1994=100
110
100
90
80
70
best gains
77 77 78 78
71 73
67 67
solid gains
81 81
83 83
86
100
negative
gains
102
105
60
50
40
Korea
Phil
UK
Malay
Italy
China
Ger
Japan
US
France
India
Twan
Spore
HK
Thai
Indon
17

Economics
Economics – Markets – Strategy
Global growth
survived the rise in
oil prices because it
drove the rise in oil
prices
Inflation presents a
serious problem to
central bankers
everywhere. But
more so in the G3
than in Asia
Will Asia immiserize the G3?
Where does all this leave us? We have noted that disaster planners could not
have invented a more hellish scenario for Asia than the current reality. US
demand growth has fallen to zero over a three year period and oil prices have
tripled over the same three years (and risen fivefold in five years). Yet rather
than collapsing, Asia continues to grow better than it should even on a clear
day.
We have argued that demand – Asian demand mostly – explains both of these
puzzles. Asian final demand kept Asia on an acceleration path for 3 years while
the US slowed. And demand, not supply, appears quite compellingly to be the
driving force behind the fivefold increase in oil prices that occurred over the
past five years.
Moreover, the data clearly show that Asia accounts for the lion’s share of the
growth in worldwide oil consumption since 2001. Indeed China and India
alone accounted for almost two-thirds of the global growth in oil consumption
between 2005 and 2006. And while a portion of this was undoubtedly intermediate
demand, the growth in Asia’s aggregate final demand – that which kept Asia
accelerating for three years while the US slowed – suggests that Asia’s demand
for oil was, likewise, made in Asia.
In short, global and especially Asian growth ‘survived’ the rise in oil prices because
it drove the rise in oil prices. An important corollary is that, unlike when prices
surge due to a contraction in supply, there is no hammer waiting to fall on
economic growth. It has already dropped, bit by bit. Higher oil prices are a
burden but when driven by an expansion in demand it is shouldered in real
time – two steps forward, one step back. Two steps forward, one step back.
And efficiency gains over the decades have helped make the backward steps
smaller.
Perhaps all this sounds too good to be true. New world this, new order that.
Everything’s paid for, nothing to worry about. The hypothetical disaster scenario
became a reality and guess what? Growth accelerated to above potential rates
and it’s still there. We met the first enemy. We outgrew him. We met the
second enemy. It is us. Things are fine.
Well....not completely. Inflation is on the rise and that presents a problem for
many a central bank, not just, and probably not mainly, in Asia. In Asia, food
has been the key driver of inflation over the past year but ex-food inflation is
accelerating now too and will soon jump much more noticeably in countries
like Indonesia, Malaysia and India, where oil-related subsidies have been cut
sharply in recent weeks. They had become too expensive for governments to
maintain.
Inflation is rising in the US and Europe too, thanks mainly to higher oil prices.
Eurozone (HICP) inflation has risen to 3.6% YoY, the highest since June 1992. US
CPI inflation has risen to 4% YoY, the highest since July 1991, save for two short
spikes (also oil related) in Sep05 and June06. With the latest surge in oil prices
(Brent crude is up by 45% since the start of the year in USD terms) inflation is
undoubtedly headed higher in the near term and central bankers on both sides
of the Atlantic are already making noises about rate hikes.
If you take the view that higher oil prices are due to temporary supply disruptions,
then hiking interest rates is probably not first-best policy, especially in the US
where domestic demand growth is already at ground-zero. Inflation would, on
18

Economics – Markets – Strategy
Economics
this view, fall back pretty quickly with or without rate hikes. So the good
news is, few would be required / delivered and the consequences for growth
would be minor.
But if you take the view, as we have, that higher oil prices are being driven by
expanding demand, then the policy prescription and the prognosis for growth
changes. A greater number of interest rate hikes would be required to tame
inflation. A greater hit to growth would result. How much growth a country
has to sacrifice would depend on its preferences toward inflation.
In Asia, inflation of 4%-8% has been the norm and the consequences to growth
of maintaining that sort of rate are probably minor. After all, ex-food inflation
in Asia is still running at only its 20-year average rate, even after a fivefold
increase in oil prices since 2003. Yes, it will no doubt rise a little above the 20-
year average in the coming year but that happens, by definition, exactly half
the time anyway. Getting back to average in Asia will be a comparatively easy
and low-cost exercise.
Compared to what? Compared to the US and Europe. Their preferences toward
inflation run on the order of 2%, not 4% to 8%. If they want to get inflation
down to 2%, they will surely have to sacrifice considerably more in the way of
growth.
Why? Because, oil prices are no longer Made in America, or in Europe. They
are made in Asia. Europe, Japan and the US all cut their oil consumption over
the past two years. Europe and Japan have been cutting it every year for a
decade. That hasn’t cut global demand. Or prevented oil prices from quintupling.
Or prevented US and European inflation from going up.
US and European central banks could raise interest rates and that would probably
lower aggregate demand in the US and Europe. GDP growth too. Alas, unless
the G3 went truly into recession, it would do little to curb Asia’s demand for
oil.
So we seem to have entered yet another brave new world. A lot of that going
around lately. Asia is driving things – important things like the price of oil, its
own rate of GDP growth and, increasingly, aggregate global demand growth
as well. Given these structural changes, is it really any surprise that it would
begin to dominate global inflation rates either?
G3 central banks and politicians in particular may not wish to accept an inflation
rate determined by Asian preferences. But to the extent they attempt to fight
it, they would only lower their (own) economic growth. Eventually of course
they would capitulate. How much growth they sacrifice on an unwinable war
is anyone’s guess. But the ECB and the Fed are either “new” or under new
leadership, or both, so the fight could be an ugly one.
Perhaps it’s not such a clear day after all.
Oil prices are
driving inflation.
But oil prices are
not made in
America or in
Europe. They are
made in Asia
G3 central banks
may have to accept
an inflation rate
made in Asia too.
That or a
permanently lower
growth rate
19

Economics
Economics – Markets – Strategy
Endnotes
1. See, for example, “Passing the Baton”, 15Jun06; “Asia driving, not decoupling”,
22Sep06; “Asia-vu”, 16Jun07; “The ‘two-fer’ rules”, 14Sep07; “The best defence”,
12Dec07.
2. Measured in sequential, quarter-on-quarter terms, US growth peaked in 3Q03
and began a four-year slowdown from there. Measured in year-on-year term,
the slowdown began in 4Q04 and has thus run for some 3.5 years.
Sources:
The source for all oil consumption and production data is the US EIA. This is annual data
and it is available through 2006. Monthly import and export data of oil and petroleum
products are generally available through April 2008 and the source is CEIC. Current
account data for global oil exporting countries comes from IFS. Data for all other charts
and tables are CEIC and Bloomberg . Estimates are by DBS Group Research.
Appendix
A1.
Asia – net oil imports and current account balances
as % of GDP, excludes natural gas
(1) (2) (2)-(1) (3) (4) (4)-(3)
C/A C/A C/A net oil M net oil M net oil M
% of GDP % of GDP % of GDP % of GDP % of GDP % of GDP
Avg 00-01 Avg 06-07 Change Avg 00-01 Avg06-07 Change
CH 1.5 9.9 8.4 1.1 2.5 1.5
HK 5.0 12.8 7.8 2.3 4.9 2.6
TW 4.5 7.7 3.2 2.5 5.1 2.6
KR 2.0 0.6 -1.4 5.5 7.4 1.9
SG 12.8 23.0 10.2 2.7 1.7 -1.0
MY 8.5 15.9 7.5 -1.9 -2.1 -0.2
ID 4.6 2.8 -1.8 -1.0 2.2 3.2
TH 6.0 3.5 -2.5 4.6 8.6 3.9
PH -2.7 4.5 7.2 4.5 6.0 1.5
IN -0.3 -1.0 -0.7 3.1 4.2 1.1
US -4.0 -5.7 -1.7 1.0 2.1 1.1
JP 2.4 4.4 2.0 1.6 3.6 2.0
Aggregates exclude Malaysia, an oil-exporting country
Asia 10 3.7 7.1 3.4 2.8 4.7 1.9
Asia 9 4.2 8.1 3.9 2.8 4.8 2.0
Asia 8 4.6 7.8 3.2 3.0 5.1 2.1
Asean5 5.2 8.4 3.3 2.7 4.6 1.9
ID, TH, PH 2.6 3.6 1.0 2.7 5.6 2.9
20

Economics – Markets – Strategy
Economics
A2.
Determinants of global petroleum demand
2005-2006
(2)-(1) chg as
(1) (2) (3) % of growth
Cons Cons Change global rate
2005 2006 06-05 total '05-'06
mn bbls mn bbls mn bbls (%) (%)
World 30,532 30,887 355
China 2,453 2,628 176 49 7.2
SArab 730 781 51 14 7.0
India 890 939 49 14 5.5
Russia 1,006 1,026 20 6 2.0
Brazil 791 809 19 5 2.3
Germany 959 973 13 4 1.4
Spore 293 305 12 3 4.1
Viet 93 100 7 2 7.6
HK 107 107 0 0 0.0
Malay 183 183 0 0 0.0
Phil 124 124 0 0 0.0
Thai 339 339 0 0 0.0
UK 670 668 -1 0 -0.2
Korea 800 793 -6 -2 -0.8
Twan 354 347 -7 -2 -2.0
Italy 641 632 -8 -2 -1.3
France 726 716 -10 -3 -1.4
Canada 838 826 -12 -3 -1.4
Mex 746 729 -18 -5 -2.4
Indonesia 464 445 -19 -5 -4.0
US 7,593 7,551 -42 -12 -0.6
Japan 1,936 1,883 -53 -15 -2.7
Asia (ex-CH, IN) 2,756 2,743 -13 -4 -0.5
CH+IN 3,343 3,567 225 63 6.7
Euro 3 2,326 2,321 -5 -1 -0.2
G3 11,855 11,755 -100 -28 -0.8
21

Currencies
Economics – Markets – Strategy
This page is intentionally left blank
22

Economics – Markets – Strategy
Currencies
FX: Slipping on oil & USD
Asia:
Much has changed during the second quarter
Oil/inflation risks have overtaken global imbalances as a key
international concern, leading the US and G7 nations to seek a stable
USD
Despite their resilience during the US subprime crisis, Asian
currencies are not faring as well against high oil prices
We have downgraded our outlook for Asia’s currencies and
postponed the next phase of regional FX appreciation to 2H09
CNY:
HKD:
TWD:
KRW:
SGD:
MYR:
THB:
IDR:
PHP:
INR:
The pace of appreciation will decelerate as overheating risks fade
and oil/inflation risks displace global imbalances atop the G7 agenda
Moving back to the upper half of the 7.75-7.85 band
Our favorite currency. Improving cross-straits relations put
economics back in focus
As weak as its international liquidity position
A higher USD/SGD is not inconsistent with an appreciating SGD
NEER policy, especially during a US rate hike cycle
Fundamentally strong but weighed down by politics
Tracking Asian currencies lower, not helped by export growth falling
below import growth
Scope to weaken beyond 9500 when US rate hike cycle starts
Typically gives back 45% of earlier gains when fundamentals turn
south
Consolidation normally follows correction, unless the stock market
enters into a freefall
VND: Full-year depreciation in 2008 is likely to be 5%-10%, not the 20%-
40% expected by the market
USD:
EUR:
Supported by rate hike expectations and policymakers signaling a
desire for a ‘strong dollar’
Downside risks from narrowing EU-US rate differentials
JPY:
From an unwinding of JPY carry trades, to USD recovery, to broad
consolidation
Philip Wee • (65) 6878 4033 • philipwee@dbs.com
CURRENCIES
23

Currencies
Economics – Markets – Strategy
USD adjustment & global imbalances – a pause before Phase III
We believe that there are three phases to the USD adjustment to address global
imbalances, with each phase separated by a US interest rate hike cycle.
Phase I took place between 2002 and 2004. The USD’s depreciation was led by
major currencies, and not by Asian currencies. Many Asian countries were not
ready to let their currencies appreciate because the global economy was just
emerging from the Y2K manufacturing recession in 2001. The capitulation of
the USD was triggered by a G7 meeting in Sep 2003, which called on China to
free its exchange rate to address global imbalances. This was viewed as a policy
shift towards a weak USD.
The USD’s depreciation paused in in 2005. The USD recovered some of its hefty
losses when it became evident that the US was raising interest rates more than
initially thought. The Fed Funds Rate was eventually raised to 5.25% from 1.00%.
Phase II is likely to have lasted between Nov 2005 and Mar 2008. The USD’s
depreciation was more evenly spread between major currencies and Asian exchange
rates. This was largely attributed to China abandoning its USD peg in Jul 2005,
with the G7 nations persistently pushing for faster appreciation thereafter. The
USD started to capitulate after the US subprime/credit crisis erupted in Jul 2007
and led to aggressive US rates cuts from 5.25% to 2.00%.
Over the next 6-12 months, we reckon that the USD will recover as the US starts
to lifting rates again. We expect the Fed Funds Rate to start rising in 4Q08 into
2Q09, lifting Fed Funds Rate from 2.00% to 4.00% by July. G7 nations, led by the
US, are also expected to push for a stable USD against major currencies to combat
inflationary expectations from high commodity prices.
Thereafter, we reckon Phase III to start in 2H09, with G7 nations resuming their
call for trade-weighted appreciation in the Chinese yuan and other Asian currecies,
notably those with large current account surpluses and robust foreign reserves.
Put simply, we are likely to see these Asian currencies appreciating not only
against the USD, but also against major currencies like the EUR.
Phase I - USD fall mainly vs major currencies
Phase II - USD fall more evenly spread
NZD
EUR
EUR
PHP
AUD
CHF
CHF
THB
GBP
AUD
CAD
SGD
JPY
CAD
KRW
JPY
THB
MYR
SGD
NZD
INR
GBP
IDR
CNY
TWD
INR
HKD
CNY
MYR
Asian currencies in red
G3 currencies in black
Other major currencies in gray
TWD
IDR
KRW
Asian currencies in red
G3 currencies in black
Other majore currencies in gray
PHP
USD
% ch vs USD
Feb 2002 to Dec 2004
HKD
USD
% ch vs USD
Nov 2005 to Mar 2008
-40 -20 0 20 40 60 80
-40 -20 0 20 40 60 80
24

Economics – Markets – Strategy
Currencies
2008 vs 2007 – what has changed?
In our last quarterly, we warned that emerging market jitters have a habit to
turning up in the second quarter, especially in years when economic and financial
uncertainties are high. We were not convinced that Asian currencies could continue
to ignore the weaknesses in their stock markets. With the exception of the Chinese
yuan, the Singapore dollar and the Taiwan dollar, most Asian currencies did
depreciate in 2Q08 (as at Jun 9).
Even as we were correct about Asian currencies returning some gains in 2Q08,
we no longer expect them to resume their appreciation in 2H08.
Over the course of the second quarter, it became evident that many of favorable
factors that drove Asian currencies higher in past two to three years have weakened.
Unlike the past couple of years, central banks in Asia are no longer intervening
this year to prevent an appreciation in their currencies, but to sell dollars to
defend their currencies.
Below are some of the changes in the currency landscape this year.
(1) Oil price shock & inflation
While Asian currencies proved their resilience to the US subprime/credit crisis,
they turned out to be vulnerable to the oil price shock. Crude oil prices based
on Nymex futures surged in 2Q08 to a record high of almost USD140/barrel on
Jun 6, after breaking decisively above USD100 in March.
Inflation requires strong policy responses to lower price pressures, which in
turn, will trim economic growth. Improvements in fiscal finances will be less
forthcoming as revenue collection slows with growth, while governments spend
to support growth. Trade balances were also pressured by costlier imports and
slower exports, leading current accounts in some countries to reverse from a
surplus into a deficit position. For several countries, inflation also sparked unrests
and increased political uncertainties. For some countries, this could lead to new
governments.
The change in this year’s landscape for Asia is best reflected by the sell-off in the
stock markets of its high-growth economies - China, India and Vietnam. As at
Jun 10, China has returned 60% of its 2005-2007 rally, with India losing the least
(41%) and Vietnam the most (85%).
(2) A significant shift on G7’s exchange rate stance
The desire for the USD to stabilize against major currencies was first expressed
at the G7 meeting in Washington on Apr 11. The communique warned about
Performance in 2Q08
CNY
SGD
1.3
0.8
Stock markets of Asia's high growth economies
Benchmark equity indices; Indexed: 1 Jan 05=100
500
China
TWD
HKD
-0.3
0.3
400
IDR
MYR
KRW
THB
INR
PHP
-6.4
-6.9
-5.2
-4.2
-2.0
-1.2
% ch vs USD
9 Jun 08 vs 31 Mar 08
-10 -5 0 5 10
300
200
India
Vietnam
100
0
Jan-05 Jan-06 Jan-07 Jan-08
25

Currencies
Economics – Markets – Strategy
sharp fluctuations in major currencies and their possible implications for economic
and financial stability.
As oil prices spiked in 2Q08, inflation became a serious policy challenge globally.
By Jun 3, this oil/inflation spiral became a problem serious enough for Fed
Chairman Bernanke to identify the USD as a risk to inflation and inflation expectations.
Bernanke’s comments came one day after US Treasury Secretary Henry Paulson
told Middle East countries not to abandon their USD pegs, reaffirming the US’s
commitment to the USD as a reserve currency. On Jun 9, Paulson did not rule
out intervention as a tool to stabilize the USD.
The G7 meeting in June is likely to reinforce its early message for the USD to
stabilize against major currencies. Although the communique is likely to continue
calling for a trade-weighted appreciation in the Chinese yuan, the market believes
that the CNY will slow its appreciation pace. This can be attributed to diminished
overheating risks in China’s economy, as well as the G7 nations prioritizing the
global oil/inflation crisis over global imbalances.
(3) US interest rates - from recession risks to inflation risks
With the US Treasury curve normalizing to an upward sloping curve from March,
the Fed has become comfortable with the market’s view that the worst was
probably over for the US mortgage crisis. Believing that recession risks have
diminished, at least relative to inflation worries, Bernanke began in June to
shift the focus of monetary policy to prevent an erosion in longer-term inflation
expectations.
Subsequently, interest rate futures market started to discount the Fed to start
taking back rate cuts this year. DBS is looking for Fed to begin hiking in 4Q08
and lift Fed Funds Rate from 2.00% to 4.00% by July 2009. While this happens,
we expect the USD to remain firm, as it did during the last rate hike cycle in
2005.
Currency revisions – postponing the next phase of Asian currency appreciation
Taking into account our rising US interest rate profile and Asia’s weakened economic
landscape, we have downgraded outlook for Asian currencies over the next 6-12
months. We are not abandoning, but merely postponing our longer-term outlook
for Asian currencies to appreciate. Like the rest of the world, Asia will be required
to bite the inflation bullet in order to return to a path of sustainable noninflationary
economic growth.
Performance in 2007
Performance in 2008 ytd
PHP
18.9
TWD
7.2
INR
12.3
SGD
5.7
THB
7.2
CNY
5.5
CNY
6.9
MYR
1.5
MYR
6.5
THB
1.4
SGD
6.2
IDR
0.8
TWD
0.3
HKD
-0.1
HKD
-0.3
PHP
-7.4
KRW
IDR
-4.3
-0.7
% ch vs USD
INR -8.0
31 Dec 07 vs 31 Dec 06 KRW -9.4
% ch vs USD
9 Jun 08 vs 31 Dec 07
-15 -10 -5 0 5 10 15 20 25
-15 -10 -5 0 5 10 15 20 25
26

Economics – Markets – Strategy
Currencies
The Good ...
The three Asian currencies that have consistently held up so far this year were
the Chinese yuan (CNY), the Singapore dollar (SGD) and the Taiwan dollar (TWD).
These three currencies share one common feature. All three favour stronger
exchange rates to fight inflation.
Of the three currencies, we like the TWD most on a relative basis. As at Jun 9,
the TWD is still the Asia’s best performing currency this year. Our optimism is
based on the return of the Kuomintang government. Since the presidential
elections in March, Cross-Straits relations have improved with policymaking
returning focus towards boosting the Taiwan economy.
On the other hand, we are wary of the SGD’s strong correlation with major
currencies, which we expect will bow to the USD’s recovery especially when the
US start hiking rates again. At witnessed in 2005, a higher USD/SGD is also not
inconsistent with an appreciating SGD NEER policy, which started in Apr 2004.
... the Bad ...
The three Asian currencies that have consistently underperformed this year were
the high yielders - Indian rupee (INR), Korean won (KRW) and the Philippine
peso (PHP). Last year’s winners - INR and PHP - turned out to be this year’s losers.
The KRW’s depreciation, which started in 2007, turned from bad to worse.
Due to increased external borrowings over the past few years, KRW and INR are
vulnerable any unwinding of JPY carry trades and shortages of USD liquidity. In
terms of international liquidity position, the KRW is considered to be more
vulnerable because external debt overtook foreign reserves in Korea, while India’s
foreign reserves continued to outpace external borrowings. Both INR and PHP
are more sensitive to downsides in their stock markets compared to the KRW.
Since they were the first to start, these three currencies are also likely to be the
first to finish returning some of the past years’ gains to the USD. Once the
correction is completed, these currencies have a track record of consolidating in
a wide range, as they await their peers in the region to do likewise.
... and the Ugly
The market is looking for the Vietnamese dong to suffer a devaluation of 20%
to 40% over the coming year. For now, we do not consider this to be an imminent
risks and sees a full-year devaluation of 5% instead in 2008. Although Vietnam
has the worst inflation and trade deficit in Asia, FDI inflows still appear to be
covering the latter.
Political risks to watch
There are three currencies with political risks that we are paying close attention
to. (1) Post-election Thai baht (THB) is persistently troubled by rumours of another
military coup, which have the potential to distract the government from the
economy. (2) Post-election Malaysian ringgit (MYR) is worried about leadership
challenges confronting its weakened prime minister. Barring political uncertainties,
the MYR is actually a fundamentally sound currency that the US Treasury considers
as undervalued. (3) The INR will be vulnerable if the protests to inflation and
higher fuel prices become loud enough for the communist allies to pull its
support from the government ahead of next year’s elections.
27

Currencies
Economics – Markets – Strategy
Fed Funds Rate
forecast, eop
Latest Prev
Close 2.00 3.00
2Q08 2.00 2.25
3Q08 2.00 2.25
4Q08 2.50 2.25
1Q09 3.25 2.75
2Q09 4.00 3.25
3Q09 4.50 4.00
4Q09 4.50 4.50
Latest close on Jun 11
Prev close on Mar 12
US dollar – weakness becomes an inflation problem
The USD is likely to have completed its second phase of adjustment that started
in Nov 2005. Unlike the first phase between 2002 and 2004, USD depreciation
was not led by major currencies this time around. Instead, the burden was shared
more evenly spread between major and Asian currencies. We reckon the third
phase will be led by Asian currencies, where those with strong fundamentals
are likely to appreciate not just against the USD, but also against the EUR and
other G7 currencies.
Before we enter into Phase III, the USD is likely to recover some lost ground
from now into mid-2009, similar to 2005 when the US hiked rates. DBS is looking
for Fed Funds Rate to rise from 2.00% to 4.25%, starting in 4Q08 into 3Q09.
The most significant development in 2Q08 was growing belief amongst policymakers
around the world that the “Weak USD” has become an inflation risk. For example,
China blamed the deep US interest rate cuts for creating inflation in emerging
markets. Increasingly, there is belief that the increased liquidity to stabilize
financial markets during the US mortgage/credit crisis facilitated speculation in
commodity markets. The US rate cuts were seen responsible for weakening the
US dollar, which in turn, implied stronger Asian currencies or increased purchasing
power from Asia for commodities.
On Jun 3, Fed Chairman Bernanke highlighted that the “weak dollar”, in shaping
inflationary expectations, is now a threat to its dual mandate to keep inflation
stable and to create jobs. Bernanke’s comments affirmed the view that the Fed
will no longer be looking to cut rates. Unlike past episodes, this should increase
the USD’s resilience to renewed financial stress going forward.
US Treasury Secretary Henry Paulson also visited the Middle East to reassure Gulf
countries that the US was committed to the USD as a reserve currency. His goal
was obviously to ensure that Gulf countries do not hurt the USD’s credibility by
abandoning their USD pegs. For the first time in a long time, Paulson did not
rule out intervention to stabilize the USD.
That said, G7 nations have not abandoned their long-time call for USD adjustment
to address global imbalances. Except that the stance has narrowed to the Chinese
yuan and other Asian currencies with large current account surpluses to bear
the adjustment burden. At its meeting in April, G7 nations warned that sharp
fluctuations in (specifically) major currencies could threaten economic and financial
stability at its April meeting. In short, G7 nations want these Asian currencies to
appreciate on a trade-weighted basis. Before this can happen, Asian currencies
will need to deal with inflation first.
Rise in oil prices are more aggressive
compared to previous USD fall in 2002-04
140
120
100
80
60
40
20
0
DXY index (rhs)
Oil prices
($/barrel, lhs)
01 02 03 04 05 06 07 08
130
120
110
100
90
80
70
60
Market is coming to our view for higher US rates
% pa
4.50
4.25
4.00
3.75
3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
DBS forecast for
Fed Funds Rate
Fed Funds Futures
as at Jun 9
Fed Funds Futures
as at Apr 30 (last cut)
Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09
28

Economics – Markets – Strategy
Currencies
Euro – relinquishing its anti-USD role
The high of 1.6018 achieved by EUR/USD on Apr 22 is likely to be the peak for
the next 6-12 months. Looking ahead, the EUR is set to lose its anti-USD role on
expectations for the EU-US interest rate differentials to narrow, as well as a
policy shift in G7’s exchange rate stance towards discouraging USD weakness.
In our opinion, the EUR/USD’s rally during the US mortgage/credit crisis from Jul
2007 to Apr 2008 did not reflect a strong EUR view, but a weak USD view driven
by aggressive US rate cuts amidst steady EU rates. Between Sep 2007 and Apr
2008, the Fed Funds Rate (FFR) fell from 5.25% to 2.00%, or half the ECB’s 4.00%
refi rate.
Looking ahead, we expect EU-US interest rate differentials to narrow, as they
always do after Eurozone loses its GDP growth advantage to the US. The Fed
should start taking back rate cuts in 4Q08, initially as an exercise to normalize
interest rates. The FFR is expected to rise to 4.50% by 3Q09 and reclaim its
positive carry against the EUR. This is not an unreasonable prospect considering
that US real interest rates, whether measured against headline CPI or core inflation,
are significantly lower than their EU counterparts.
There was also a major shift in the G7’s stance on exchange rates in 2Q08. At its
meeting in April, G7 nations warned that sharp fluctuations in major currencies
could threaten economic and financial stability. After EUR/USD rose above 1.50,
Eurozone officials persisently complained about the EUR’s overvaluation and
the USD’s undervaluation.
Lending support here is the US-EU trade deficit, which is set to narrow for the
third straight year in 2008 to below USD100bn for the first time since 2003.
Eurozone also reported a current account deficit of EUR17.8bn in 1Q08, its worst
level since 2Q01. If this persist, it will be the first since 2001 that Eurozone
posted a current account deficit.
EUR/USD
forecast, eop
Latest Prev
Close 1.56 1.55
2Q08 1.55 1.48
3Q08 1.52 1.50
4Q08 1.49 1.54
1Q09 1.46 1.50
2Q09 1.43 1.49
3Q09 1.45 1.48
4Q09 1.46 1.48
ECB refi rate
forecast, eop
Latest Prev
Close 4.00 4.00
2Q08 4.00 4.00
3Q08 4.25 4.00
4Q08 4.25 4.00
1Q09 4.25 4.00
2Q09 4.25 4.00
3Q09 4.25 4.00
4Q09 4.25 4.00
Latest close on Jun 11
Prev close on Mar 12
These initial currency complaints by EU officials initially fell on deaf ears, that is
until the US Treasury and the Fed acknowledged in June that the weak USD was
responsible for fueling inflationary expectations by boosting commodity prices,
especially food and energy prices. Given that EUR accounts for 57.6% of the
weight in the the DXY (USD) index, this implies that the firmer USD sought by
G7 to rein in commodity prices will inadvertently imply a weaker EUR.
During the US rate hike cycle in 2005, EUR/USD returned close to 40% of its
three-year rally from 2002 to 2004. If history repeats itself in the coming US
tightening cycle, EUR/USD has potential to fall back towards 1.43 by mid-2009.
EU-US policy rate spread to fall with GDP spread
2
1
0
-1
-2
-3
EU-US
GDP growth
spread, % YoY
EU-US
policy rate
spread, % pa
96 97 98 99 00 01 02 03 04 05 06 07 08
G7 seeks a firmer USD (or weaker EUR) should pull
down commodity prices
440
420
400
380
360
340
320
300
280
260
CRB index
(lhs)
Jan-07 Jul-07 Jan-08
EUR/USD
(rhs)
1.65
1.60
1.55
1.50
1.45
1.40
1.35
1.30
1.25
29

Currencies
Economics – Markets – Strategy
Japanese yen – entering in a post-US crisis consolidation
USD/JPY
forecast, eop
Latest Prev
Close 107 103
2Q08 107 105
3Q08 108 100
4Q08 109 98
1Q09 110 100
2Q09 109 100
3Q09 108 101
4Q09 106 101
BOJ o/n target rate
forecast, eop
Latest Prev
Close 0.50 0.50
2Q08 0.50 0.50
3Q08 0.50 0.50
4Q08 0.50 0.50
1Q09 0.75 0.75
2Q09 0.75 0.75
3Q09 1.00 1.00
4Q09 1.00 1.00
Latest close on Jun 11
Prev close on Mar 12
We are looking for USD/JPY to enter into a broad consolidation, which normally
takes place after the end of a US financial crisis. We do not expect the next US
rate hike cycle to encourage a return to JPY carry trades because record high oil
prices and inflation worries worldwide have resulted in a shift in G7’s stance on
exchange rates.
Over the past decade or two, the major peaks in USD/JPY were heralded by a US
financial crisis in the US. This time, it was attributed to the US subprime/credit
crisis. Interestingly, the peak in 1990 was also due to US housing woes known as
the savings and loans crisis.
As witnessed in past episodes, the initial fall in USD/JPY was fast and deep,
resulting mainly from an aggressive unwinding of carry trades, often triggered
by Fed rate cuts to stabilize financial markets. Based on daily closes, the fall in
USD/JPY amounted to 27 yen during this crisis. The amount was between the 39
yen fall seen during the Long Term Capital Management (LTCM) crisis in 1998,
and the 19 yen fall during the WorldCom crisis. Thereafter, USD/JPY will bottom
once it becomes evident that the worst was over for the US financial crisis. For
this experience, USD/JPY’s bottom was established around 97 in March after the
Fed successfully pre-empted a potential fallout from Bears Stearns.
Once a bottom is established, USD/JPY will embark on a post-recovery crisis. The
LTCM and WorldCom experiences saw USD/JPY rebound by 9-13 yen from its
low. This implies that today’s relief rally in USD/JPY should be limited to 106-
110. Thereafter, USD/JPY should enter into a consolidation before resuming its
fall, which historically came 4-5 quarters after its first bottom. Assuming March
as the bottom for this episode, the consolidation is likely to last till 2Q09, and
probably see USD/JPY mostly bound between 102 and 108 during this period.
For the above scenario to work, the JPY must not reprise its role as a funding
currency for carry trades as it did during the last US rate hike cycle from 2004 to
2006. For carry trades to work, the environment must also be friendly for high
yield currencies, which happen to be commodity currencies like the Australian
dollar. Put simply, carry trades successful before the US crisis because the weak
USD increased the purchasing power of Asian currencies and fueled speculation
in commodities. Looking ahead, this is no longer the case. Inflation has started
to erode the purchasing power of Asian currencies. US and the G7 nations are
hinting strongly that the USD must stop depreciating (at least against major
currencies) to rein in the record high oil prices seen threatening economic and
financial stability.
USD/JPY - big picture sees consolidation within big range before the next fall
170
160
150
S&L
LTCM
140
130
120
110
100
WorldCom
Subprime
90
80
G3 interventions
BOJ
interventions
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
30

Economics – Markets – Strategy
Currencies
Chinese yuan – appreciation pace to slow with diminished overheating risks
We are reining back our expectations for CNY appreciation. The factors responsible
for faster pace of appreciation since Jul 2005 have weakened in 2008. For 2008,
we now expect CNY to rise by a smaller 8.1% appreciation against USD, compared
to 12% previously. We have also slowed the appreciation for 2009 to 4.7% from
5.5% previously. This should translate into a USD/CNY rate of 6.75 and 6.45 by
the end of 2008 and 2009 respectively.
Since its de-peg in Jul 2005, the CNY has been increasing its appreciation pace.
Initial pressures came from the US-led G7 nations, triggered mainly by China’s
ballooning trade surpluses and the widening bilateral US-China trade deficit. As
time progressed, the pressures for faster CNY appreciation started to come more
from domestic sources, namely as a need to pre-empt overheating pressures. By
2007, China’s economy posted its fifth straight year of double-digit growth with
inflation becoming a serious concern after it rose above 5% from Jul07. The
Chinese stock market was the toast of equity investors, as the the Shanghai
Composite Index increased almost six-fold between Jul 2005 and Oct 2007. Thanks
to robust trade and capital inflows, foreign reserves surged to USD1.76 trillion
in Apr08, a whopping trillion richer than the USD733bn posted in Jul05.
Hence, it did not come as a surprise that the NDF (non-deliverable forward)
market was pricing for faster and faster CNY appreciation throughout 2007 into
1Q08. At its peak on Mar 13, the NDF market was projecting an appreciation of
13% over the next 12 months. Since then, that expectation has whittled to
4.9% by Jun 11.
So, what has changed? For a start, investors are finding it difficult to ignore the
struggling stock market, where the Shanghai Composite Index has fallen more
than 70% from its peak. Like it or not, the stock market decline coincided with
the slowdown in the economy. GDP growth decelerated for the second straight
quarter to 10.6% in 1Q08, below 11% for the first time since 4Q05. Another
surprise was the trade surplus, which narrowed in the first four months from a
year ago levels. The same narrowing was also seen in the bilateral US-China
trade deficit. Understandably, the central bank is becoming comfortable that
overheating risks have diminished.
USD/CNY
forecast, eop
Latest Prev
Close 6.92 7.10
2Q08 6.90 6.90
3Q08 6.80 6.70
4Q08 6.75 6.50
1Q09 6.70 6.30
2Q09 6.65 6.26
3Q09 6.55 6.21
4Q09 6.45 6.16
PBOC 1Y lending
forecast, eop
Latest Prev
Close 7.47 7.47
2Q08 7.47 7.74
3Q08 7.47 8.01
4Q08 7.74 8.01
1Q09 8.01 8.01
2Q09 8.28 8.01
3Q09 8.28 8.01
4Q09 8.28 8.01
Latest close on Jun 11
Prev close on Mar 12
Even so, these factors are not sufficient to abandon the CNY’s appreciation bias.
China is still reporting double-digit growth, foreign reserves are still rising strongly
and trade surpluses are still wide. But they are no longer flagging large overheating
risks. With US and G7 no longer pushing hard for a weak USD because of the oil
crisis, there’s a case to scale back appreciation expectations for the CNY.
Market sees CNY slowing appreciation pace
China stocks anticipated GDP slowdown
24
22
20
18
16
14
12
10
8
6
4
2
USD/CNY
1Y NDF (rhs)
% appreciation
implied by 1Y NDF
Jan-05 Jan-06 Jan-07 Jan-08
USD/CNY
Spot (rhs)
8.50
8.00
7.50
7.00
6.50
6.00
5.50
5.00
4.50
4.00
3.50
12.5
12.0
11.5
11.0
10.5
10.0
GDP growth
(% YoY, lhs)
Shanghai Comp
Index (rhs)
Jan-05 Jan-06 Jan-07 Jan-08
7000
6000
5000
4000
3000
2000
1000
0
31

Currencies
Economics – Markets – Strategy
USD/HKD
forecast, eop
Latest Prev
Close 7.81 7.79
2Q08 7.81 7.80
3Q08 7.83 7.77
4Q08 7.83 7.75
1Q09 7.85 7.78
2Q09 7.85 7.78
3Q09 7.83 7.78
4Q09 7.80 7.79
3M Hibor
forecast, eop
Latest Prev
Close 2.15 2.14
2Q08 1.75 1.75
3Q08 1.95 1.85
4Q08 2.35 1.85
1Q09 3.05 2.63
2Q09 3.70 --
3Q09 4.20 --
4Q09 4.15 --
Latest close on Jun 11
Prev close on Mar 12
Hong Kong dollar – peg intact despite surge in CNY deposits
USD/HKD bottomed at 7.76 on Mar 17 and proceeded to rise above 7.80 again
on May 20. Some market players blamed the HKD’s weakness on more Hong
Kongers opening CNY deposits. Instead, we prefer to attribute this to the broad
USD’s recovery on growing market belief that the worst was over for the US
subprime/credit crisis.
Nonetheless, the rapid growth of CNY deposits in Hong Kong in 2008 has attracted
sufficient attention to warrant some discussion. Since the start of this year, CNY
deposits surged to CNY76.6bn by Apr08, more-than-doubled the CNY33.4bn reported
in Dec07.
The interest in CNY deposits as an alternative asset class was probably triggered
by the sharp 35% fall in HK equities from Nov 2007 into Mar 2008. As China’s
stock market fell 50% from its peak, earlier optimism surrounding the “throughtrain”
scheme to allow individual mainland Chinese to invest directly in HK
equities evaporated. Not surprisingly, CNY deposits started to make sense to
Hong Kongers as they turned their attention towards the divergent monetary
policies of the mainland and the territory. While Hong Kong’s monetary policy
was tracking the Fed in lowering interest rates, China was visibly accelerating
the CNY’s appreciation to augment its fight against rising inflation and overheating
risks.
That said, this surge in CNY deposits is unlikely to pose a serious threat to the
HKD peg. As at Apr08, CNY deposits accounted for only 1.2% of total outstanding
deposits in the territory. Looking ahead, we also expect HK interest rates to
start rising with the Fed from 4Q08 into 3Q09. Meanwhile, China is starting to
show signs that it may be looking to slow the CNY’s appreciation pace on signs
overheating risks may be ebbing.
In 2Q08, the HKD peg was not spared from speculation that Middle East countries
are considering abandoning their USD pegs to fight inflation. The Hong Kong
Monetary Authority (HKMA) duly ruled out changing the HKD peg to ease rising
price pressures. The World Bank and the IMF reiterated their support for HK’s
commitment to the peg.
Looking ahead, we prefer to focus on broad USD trends, especially those against
Asian currencies, in shaping the view for the HKD. We also reckon that the
world now considers record high oil prices a threat to the economic and financial
stability in the world. Looking ahead, we reckon that G7 nations believe that
ending the USD’s weakness against major currencies will be the first important
step towards lowering oil prices.
USD/HKD bottomed as USD recovered on hopes
that worst is over for US financial crisis
130
125
120
115
USD/HKD
(rhs)
7.84
7.82
7.80
Bearish HK equities probably encouraged interest
in CNY deposits
35000
30000
25000
Hang Seng
Index (lhs)
90
80
70
60
50
110
105
100
95
USD/JPY
(lhs)
Jan-07 Jul-07 Jan-08
7.78
7.76
7.74
20000
15000
10000
CNY deposits in HK
(CNY bn, rhs)
Jan-05 Jan-06 Jan-07 Jan-08
40
30
20
10
0
32

Economics – Markets – Strategy
Currencies
Taiwan dollar – moving towards closer ties and cooperation with China
The TWD was the best performing currency in emerging Asia in 1H08. Most of
these gains were achieved in 1Q08 in celebration of the end of the Democratic
Progressive Party’s (DPP) eight-year rule. Optimism first set in after the opposition
Kuomintang (KMT) swept 86 out of the 113 seats at the Legislative Yuan elections
on Jan 12. The DPP’s defeat was complete after KMT candidate Ma Ying-jeou
won 58.45% of the votes at the presidential elections on Mar 22. Ma was inaugurated
as Taiwan’s president on May 20.
With the KMT in charge, investors are looking forward to better Cross Straits
relations, which have been strained under the DPP’s rule. Despite the earthquake
in China, Beijing extended an invitation on May 17 to KMT chairman Wu Pohhsiung
to meet with China President Hu Jintao on May 26. This was a landmark
meeting signaling warming ties because it was the first time in 60 years that the
leaders of the ruling parties in China and Taiwan met.
Some of positive developments discussed so far included possible plans for China
to move towards reducing the number of missiles aimed at Taiwan. In response
to President Hu’s offer to reconsider not blocking Taiwan’s efforts for greater
particpation in international activities (for example, attendance at the World
Health Organization), Taiwan offered to reduce “chequebook diplomacy”.
In affirming the resumption of dialogue between Taipei and Beijing, the above
developments are important building blocks towards achieving President Ma’s
pledge to build closer business ties with China to boost Taiwan’s economy.
July will be an important month signaling the first important steps towards
closer economic cooperation. Jul 4 is the day that weekend direct flights are
scheduled to be launch between China and Taiwan. The Taiwan parliament is
also working hard to finalise plans for full yuan convertibility in July. These
developments are likely to pave the way for more Chinese to visit Taiwan as
tourists and investors, as well as to encourage Taiwan to ease restrictions on
investments by local companies in China.
Overall, we are encouraged by the initial gestures by China and Taiwan in resuming
dialogue and improving economic cooperation. While the TWD is unlikely to
buck the trend of a USD recovery, we see scope for the TWD to maintain an
advantage over other Asian currencies including the JPY on a relative basis.
Nonetheless, we do expect USD/TWD to maintain its traditionally strong link to
USD/JPY. Unless Taiwan attracts huge capital inflows, USD/TWD should hold above
the psychological 30 level until USD/JPY falls below 100 again.
USD/TWD
forecast, eop
Latest Prev
Close 30.4 30.7
2Q08 30.4 31.0
3Q08 30.5 30.5
4Q08 31.0 29.5
1Q09 31.5 30.5
2Q09 32.0 30.4
3Q09 31.5 30.2
4Q09 31.0 30.0
CBC discount rate
forecast, eop
Latest Prev
Close 3.500 3.375
2Q08 3.625 3.625
3Q08 3.750 3.625
4Q08 3.875 3.625
1Q09 3.875 3.625
2Q09 3.875 3.625
3Q09 3.875 3.625
4Q09 3.875 3.625
Latest close on Jun 11
Prev close on Mar 12
TWD & equities cheered by prospects for
improving Cross-Straits relations
10000 USD/TWD
Presidential elections
(rhs)
Inauguration
9500
34
33
Larger influence on USD/TWD comes from
USD/JPY
125
120
USD/TWD
(rhs)
34
33
9000
8500
8000
32
31
115
110
105
32
31
7500
TAIEX
(lhs)
Legislative
elections
30
100
USD/JPY
(lhs)
30
7000
Jan-07 Jul-07 Jan-08
29
95
Jan-07 Jul-07 Jan-08
29
33

Currencies
Economics – Markets – Strategy
USD/KRW
forecast, eop
Latest Prev
Close 1030 971
2Q08 1035 1000
3Q08 1075 980
4Q08 1100 940
1Q09 1075 980
2Q09 1075 980
3Q09 1050 982
4Q09 1050 982
BOK o/n call rate
forecast, eop
Latest Prev
Close 5.00 5.00
2Q08 5.00 5.00
3Q08 5.00 5.00
4Q08 4.75 5.00
1Q09 4.50 5.00
2Q09 4.50 5.00
3Q09 4.50 5.00
4Q09 4.50 5.00
Latest close on Jun 11
Prev close on Mar 12
Korean won – weakened international liquidity position
We downgraded our forecast for KRW on Apr 24. Instead of expecting the KRW
to appreciate against USD to 940 by end-2008, we see the risk for the KRW to
depreciate to 1050-1100 in the second half of the year instead.
Interestingly, the last time the KRW depreciated as dramatically as today was
back in 2001-02. Like the Y2K crisis back then, it was the subprime/credit crisis
that threatened to push the US economy into recession. Both periods witnessed
the Fed delivering inter-meeting rate cuts. But there is one difference. Foreign
reserves were rising to overtake foreign debt back then. Today, external debt
has already overtaken foreign reserves.
The first hint of the KRW’s weakness surfaced during the US mortgage/credit
crisis that broke out in Jul 2007. Despite aggressive cuts in US interest rates, the
KRW depreciated instead of appreciating. Another disturbing development was
the vulnerability of the KRW to unwinding of JPY carry trades or shortages of
USD liquidity. Instinctively, we reckoned that there was a weakening in Korea’s
international liquidity position. Our investigations did not let us down.
Over the past few years, Korean banks were aggressively expanding their loans
books. But there was one problem -- loans already exceeded deposits. To continue
the practice of lending aggressively, banks borrowed heavily from foreigners to
make up the funding gap. Why not? Back then, the KRW was considered one of
the best Asian currencies to invest in, while the JPY emerged as a funding currency
for carry trades. This eventually led to gross external debt overtaking foreign
reserves in 2Q06, with the debt-reserves shortfall widening to USD118bn in 4Q07.
The last time the shortfall exceeded USD100bn was just before the 1997/98 Asian
financial crisis.
That said, we are not suggesting that Korea is about to enter into a crisis. The
trigger for the Korean crisis in 1997/98 was the lack of foreign reserves to cover
short-term external debt. Today, this is not the case, at least not yet. Even so,
there is little room for complacency either. Left unaddressed, the rapid rise in
short-term external debt is projected overtake foreign reserves by 2012. With
international ratings agencies now concerned about the banks’ heavy reliance
on short-term external borrowings, expect the government to introduce measures
to address this issue.
Under the circumstances, it did not bode well that the current account (CA)
reported a deficit of USD5.2bn in 1Q08, contrasting sharply with the full-year
USD6.0bn surplus in 2007. If the deterioration persists, this will be the first year
that Korea posts a CA deficit after the Asian crisis.
Korean banks are relying heavily on external
borrowings to lend
140 USD bn
120
100
80
60
40
20
0
-20
-40
Commercial banks'
loans less deposits
External debt,
YoY difference
01 02 03 04 05 06 07 08
Korea needs to address its rising external debt
450
400
350
300
250
200
150
100
50
0
USD bn
Gross external debt
Gross external assets
Foreign
reserves
Short-term
external debt
96 97 98 99 00 01 02 03 04 05 06 07 08
34

Economics – Markets – Strategy
Currencies
Singapore dollar – a higher USD/SGD is not inconsistent with a rising SGD NEER
Based on our expectations for the USD to recover some lost ground, as well as
continued weakness in Asian currencies, we now see upside risks for USD/SGD to
rise towards 1.44 in the next 6-12 months.
Over the past two years, the market has become accustomed to associating a
lower USD/SGD with a strong SGD NEER (nominal effective exchange rate) policy.
More so after USD/SGD increased the pace of its fall with each tightening at its
last two Monetary Authority of Singapore (MAS) policy reviews 1/ . We have no
problem with this association as long as the USD is depreciating against the SGD
NEER’s trade-weighted basket of currencies.
At this point, we would also like to remind readers that USD/SGD can head up
despite a strong SGD NEER policy. For example, USD/SGD rose from 1.6327 to
1.6627 in 2005, even after MAS shifted in Apr 2004 to a policy of appreciating
the SGD NEER at a modest and gradual pace. During 2005, after USD/SGD bottomed
at 1.6180 on Mar 10, it surged 5.3% to 1.7051 on Nov 14 before resuming its
downtrend. The reason for this was simple. The USD was firm because the US
was in the process of raising interest rates from 1.00% to 5.25%. This led to a
broad-based USD recovery against both major currencies and Asian currencies.
Like today, record high oil prices became a problem for some Asian economies,
and forcing neighbouring countries like Indonesia to cut fuel subsidies.
Currently, we see upside risks in USD/SGD coming mainly from major currencies.
Since the outbreak of the US subprime/credit crisis in Jul 2007, the SGD has
broken ranks with Asian currencies and closely followed the major currencies
stronger. To facilitate this dichotomous behaviour, the MAS had to re-center its
SGD NEER policy band at its policy review in April.
USD/SGD
forecast, eop
Latest Prev
Close 1.37 1.38
2Q08 1.37 1.41
3Q08 1.38 1.38
4Q08 1.40 1.35
1Q09 1.42 1.38
2Q09 1.44 1.37
3Q09 1.42 1.37
4Q09 1.40 1.36
3M Sibor
forecast, eop
Latest Prev
Close 1.44 1.31
2Q08 1.16 1.13
3Q08 1.31 1.14
4Q08 1.52 1.13
1Q09 1.94 1.49
2Q09 2.31 2.79
3Q09 2.67 2.30
4Q09 2.64 2.60
Latest close on Jun 11
Prev close on Mar 12
This goes some way to explain why the MYR/SGD cross rate has weakened below
its 0425-0.452 range, while the EUR/SGD cross rate appears to be establishing
stable 2.10-2.18 trading range. This should not come as a surprise since Malaysia
is still Singapore’s largest trading partner in Asia, while Eurozone has overtaken
the US as the largest amongst the developed economies.
Unless the MAS is seeking to re-center its band before its next policy review in
October, we urge readers to pay close attention to EUR/USD, whose fall is likely
to push up USD/SGD.
1/
In Oct 2007, the MAS “slightly” increased the appreciation pace of the SGD NEER policy band.
This was followed by a re-centering of the SGD NEER band in Apr 2008. Both tightening were
aimed at reining in inflation, which rose to a 26-year high of 7.5% in Apr08.
SGD has been tracking major currencies since
the start of the US crisis
104 Performance of USD vs currencies
Indexed: 15 Jul 07 = 100
102
100
98
96
94
92
90
88
86
Major currencies
(implied by DXY index)
Asian currencies
(implied by ADXY index)
SGD
Jul-07 Oct-07 Jan-08 Apr-08
USD/SGD & SGD NEER can diverge occasionally
108
106
104
102
100
98
96
94
2005 US
rate hike
cycle
Re-centering
Appreciation
pace increased
USD/SGD (rhs)
Start of strong SGD policy
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
SGD
NEER
(lhs)
1.75
1.70
1.65
1.60
1.55
1.50
1.45
1.40
1.35
1.30
35

Currencies
Economics – Markets – Strategy
USD/MYR
forecast, eop
Latest Prev
Close 3.27 3.18
2Q08 3.27 3.25
3Q08 3.30 3.15
4Q08 3.35 3.00
1Q09 3.40 3.15
2Q09 3.45 3.14
3Q09 3.40 3.14
4Q09 3.35 3.13
BNM o/n policy rate
forecast, eop
Latest Prev
Close 3.50 3.50
2Q08 4.00 3.50
3Q08 4.00 3.50
4Q08 4.00 3.50
1Q09 4.00 3.50
2Q09 4.00 3.50
3Q09 4.00 3.50
4Q09 4.00 3.50
Latest close on Jun 11
Prev close on Mar 12
Malaysian ringgit – dominated by political uncertainties
As predicted in our previous quarterly, the appreciating MYR corrected in 2Q08.
The MYR appreciated to 3.1280 against the USD on Apr 23, its strongest level
since Oct 1997. Like other Asian currencies, the MYR succumbed to a stronger
USD on market expectations for the US to start taking back its rate cuts as early
as 4Q08. Domestically, the MYR was also undermined by post-election political
uncertainties, the key risk confronting the MYR this year
Uncertainties emerged after the ruling Barisan Nasional (BN) coalition lost its
two-thirds parliamentary majority at the general elections held on Mar 8. The
coalition also ceded control of 5 out of the 13 states to the opposition. Since
then, PM Abdullah Badawi has been facing increasing pressures to step down.
His predecessor, Mahathir Mohamad, quit the United Malaysia National Organization
(UMNO) on May 20 in protest of Badawi’s leadership. Oppositon leader Anwar
Ibrahim declared his intention to seize power by persuading BN lawmakers to
defect to his coalition. Anwar is hoping that the unpopular fuel price hikes
would hasten the fall of the BN coalition. For now, the prime minister’s fate is
expected to be decided at the UMNO annual congress due in Dec 2008.
Adding to political uncertainties here is the government’s decision to reform
fuel subsidies on Jun 4. While this is positive for cushioning Malaysia’s fiscal
finances against record high international energy prices, the subsequent 41%
jump in petrol prices and 63% rise in diesel prices are likely to add to inflation.
To ease the pain on consumers, the government intends to widen the social
safety net for the poor, encourage government department to save costs, widen
the list of price-controlled items and make a decision by August whether to
reduce road toll rates.
Politics aside, we do expect the fuel price hikes to lift inflation to 5.8% YoY in
Jun08. Inflation has already doubled to 3.0% YoY in Apr08 from 1.4% in Jun07.
Hence, Bank Negara Malaysia (BNM) is now expected to hike its overnight policy
rate by 50bps to 4.00%, which will be its first rate move since May 2006.
As for the MYR, the KL stock market index will become an important gauge of
investor sentiment to domestic politics. In the end, we expect BNM to maintain
control of the exchange rate and keep the MYR aligned to Asian currencies.
Without the political uncertainties, the MYR would have been a strong currency.
Unlike many of its Asian peers, Malaysia’s trade surpluses are not threatened by
costlier energy imports, thanks to its net oil exporter status. In its latest semiannual
currency report, the US Treasury considers the MYR an undervalued currency
based on its large current account surpluses and low domestic investment.
MYR is no longer ignoring downside risks in stocks
1700
1600
1500
1400
1300
1200
1100
1000
900
USD/MYR
(inverted, rhs)
KL Composite
index (lhs)
3.10
3.20
3.30
3.40
3.50
3.60
3.70
3.80
Trade surpluses held up against record oil prices
MYR bn
12
10
8
6
4
2
0
-2
800
Jan-05 Jan-06 Jan-07 Jan-08
3.90
-4
96 97 98 99 00 01 02 03 04 05 06 07 08
36

Economics – Markets – Strategy
Currencies
Thai baht – tracking Asian currencies lower
The sharp appreciation of the THB in the first 3.5 months of 2008 can be attributed
to the return of democracy to Thailand in Dec/Jan and the end of capital controls
in Feb. Since peaking at 31.00 on Mar 19, the THB has been weakening with its
counterparts in Asia. In reviewing the THB, we find that the factors that were
responsible for a stronger THB in the past two years have weakened in 2008.
In 2006 and 2007, the appreciation pace of the THB quickened against the USD.
This was easily explained by the aggressive build-up in foreign reserves, which
started to overtake external debt from Apr 2006. One major contribution to the
foreign reserves was the current account balance, which reversed from a deficit
into a surplus in 2006, and proceeded to report a record USD14.9bn surplus in
2007. Playing a major role here was export growth exceeding import growth.
Interest rate cuts in 2007 also helped real GDP growth to rise for four straight
quarters to above 6% YoY in 1Q08. Quarterly inflation stayed low below 3%
YoY in 2007. Equally important is the appreciation in Asian currencies in the
past couple of years, thanks to aggressive US rate cuts.
Several things changed in 2008. The most important challenge comes from record
oil prices, which is hurting both inflation and the trade balance.
The customs trade balance reversed from a surplus into a deficit totaling USD3.0bn
in the first four months. This was attributed to a 39.6% YoY surge in imports
outstripping export growth of 21.4% during this period, which contrasted with
the 8.7% import growth and 18.0% export growth posted in 2007. Take note
that USD/THB was range-bound between 38.2 and 42.0 when import growth
overtook export growth in 2004 and 2005.
Between Aug07 and May08, headline CPI inflation surged to 7.6% YoY from
1.1%, while core inflation quadrupled to 2.8% from 0.7%. With the policy rate
at 3.25%, the Bank of Thailand (BOT) will be increasingly pressured to hike rates
to keep core inflation within the official 0-3.5% target band. Unfortunately, the
central bank is facing resistance to hike rates from the new government’s progrowth
economic policy. If policymakers fail to agree here, inflation has the
potential to spark social unrest and add fuel to coup rumours.
In the end, we anchor our THB view on one thing that policymakers agree upon.
Both the BOT and the finance ministry believe that the THB should be aligned
to Asian currencies. Given our expectation for the USD to stay firm into 2Q09 on
the back of US rate hikes, we see USD/THB extending its rise towards 35 in the
next 6-12 months.
USD/THB
forecast, eop
Latest Prev
Close 33.1 31.6
2Q08 33.0 33.0
3Q08 33.5 32.0
4Q08 34.0 30.0
1Q09 34.5 31.0
2Q09 34.9 30.9
3Q09 34.1 30.8
4Q09 33.4 30.7
BOT 1D repo rate
forecast, eop
Latest Prev
Close 3.25 3.25
2Q08 3.25 3.25
3Q08 3.25 3.25
4Q08 3.75 3.75
1Q09 3.75 4.00
2Q09 3.75 4.25
3Q09 3.75 4.25
4Q09 3.75 4.25
Latest close on Jun 11
Prev close on Mar 12
THB falls when export underperforms imports
% YoY 3mth move ave, spot
40
USD/THB
(inverted, rhs)
30
20
10
0
-10
-20
-30
Export growth
less import growth
04 05 06 07 08
30
32
34
36
38
40
42
44
Policymakers must agree to deal with inflation
% YoY, % pa
8
7
6
5
4
3
2
1
0
-1
Fed Funds Rate
BOT policy rate
TH
core CPI
00 01 02 03 04 05 06 07 08
TH CPI
37

Currencies
Economics – Markets – Strategy
Indonesian rupiah – moving above 8700-9500 range
USD/IDR
forecast, eop
Latest Prev
Close 9310 9160
2Q08 9300 9300
3Q08 9500 9000
4Q08 9600 8700
1Q09 9700 9000
2Q09 9800 9000
3Q09 9500 8980
4Q09 9300 8980
BI benchmark rate
forecast, eop
Latest Prev
Close 8.50 8.00
2Q08 8.75 8.00
3Q08 9.25 8.00
4Q08 9.25 8.00
1Q09 9.25 8.00
2Q09 9.25 8.00
3Q09 9.25 8.00
4Q09 9.25 8.00
Latest close on Jun 11
Prev close on Mar 12
Since 2006, Bank Indonesia (BI) has successfully kept USD/IDR stable in a broad
range between 8700 and 9500. We think that this is about to change.
Despite oil prices surging to USD98/barrel from USD61 in 2007, depreciation
pressures on the rupiah were offset by a number of factors. To a great extent,
the central bank’s ability to maintain a stable rupiah could be attributed to the
reflationary environment that followed the aggressive fuel price hikes in Oct
2005. As inflation eased from a high of 18.4% YoY in Nov 2005 to a stable range
between 5.3% and 7.0% from Oct 2006 to Dec 2007, the central bank lowered
interest rates from 12.75% to 8.00%.
During these two years, the Jakarta stock market delivered annual gains of more
than 50%, correctly betting on economic growth to return to pre-crisis levels
above 6%. Meanwhile, foreign reserves started to accummulate at a faster rate
from 2006, and overtook private sector external debt in 2007. The merchandise
trade surplus was strong at almost USD40bn in 2006 and 2007, well above the
average USD26bn posted in the previous eight years. This helped to assuage
concerns about Indonesia’s net oil importer status. Of course, it did not hurt
that the USD was weak internationally from the aggressive rate cuts during the
US mortgage/credit crisis that started in Jul 2007.
Unfortunately, this did not last. The positive factors responsible for rupiah stability
in the past couple of years started to deteriorate in 2008. As at Jun 2, the stock
market has fallen by 12% since the start of the year, in line with waning consumer
confidence. Oil prices have become a problem as they extended their ascent to
as high as USD133/barrel on May 21. Apart from lifting inflation to double-digit
levels by May08, high oil prices started to strain fiscal finances as well as to
narrow the trade surplus. BI brought forward its policy meeting by two-days to
May 6 and lifted the reference rate by 25bps hike to 8.25%. To alleviate the
pressures on fiscal finances from record high oil prices, the government raised
fuel prices by 28.7% on May 24, leaving the door open for more hikes and fuel
subsidy cuts should the oil prices continue to climb unabated.
Under the circumstances, the rupiah will be vulnerable if the US embarks on a
rate hike cycle, like in 1999-00 and 2004-06. Starting from 4Q08 into 3Q09, DBS
expects the Fed to raise interest rates from 2.00% to 4.25%. Hence, it will become
more challenging for BI to keep USD/IDR within its 8700-9500 range. Taking into
account that rupiah depreciation has become more muted with each cycle, we
reckon that the upside for USD/IDR will be limited to 9800-10000 by mid-2009
before coming down again.
USD/IDR rises during US rate hike cycle
% pa, spot
14
12
10
8
6
4
2
USD/IDR
(rhs)
Fed Funds Rate
0
99 00 01 02 03 04 05 06 07 08
12000
11000
10000
9000
8000
7000
6000
5000
4000
3000
Jakarta stocks - first losses since 2001
Jakarta Composite Index, % YoY annual changes
70
60
50
40
30
20
10
0
-10
-20
2008 data: % ch YTD as at Jun 2
01 02 03 04 05 06 07 08
38

Economics – Markets – Strategy
Currencies
Philippine peso – deep retracement on less favorable fundamentals
In our last quarterly, we expected USD/PHP to head up in 2Q08, as it normally
does during the second quarter of the year. We also reined in our bullish PHP
expectations because the factors that were responsible for the PHP’s three-year
rally between 2005 and 2007 have started to weaken. The deterioration was,
however, not severe enough for us to abandon our expectations for PHP to
appreciate for a fourth year. Back then, the USD continued to be stressed by the
US mortgage/credit crisis.
Nonetheless, the PHP’s weakness in 2Q08 turned out to be more significant than
we had expected. Unlike past years, Bangko Sentral ng Pilipinas’ (BSP) interventions
were aimed at curbing currency depreciation, and not to slow appreciation.
More worryingly, USD/PHP traded above the accelerating depreciation band
that it has been tracking during 2005-2007. After reviewing the factors that
were responsible for the PHP’s appreciation during 2005-2007, our findings suggest
that the PHP is no longer likely to appreciate for a fourth straight year in 2008.
What changed? The PHP’s rally during 2005-2007 was characterized by rising
economic growth and falling inflation. Both the budget and current account
balances improved significantly. Foreign reserves increased sharply, thanks also
to strong contributions from overseas foreign worker remittances. As investor
confidence increased, the stock market entered into a bull run. The USD was
also weak against Asian currencies, especially after China abandoned its currency
peg in Jul 2005.
In 2008, these fundamentals turned less favorable. The economy is unlikely to
repeat last year’s stellar performance. To support growth, the Arroyo government
abandoned its goal to balance the budget in 2008. Slower growth propsects are
likely to pressure the budget deficit wider by slowing revenue collection and
increasing government spending. Meanwhile, inflation reared its ugly head,
no thanks to higher international commodity prices. Owing to more expensive
food and energy imports, the trade deficit has already widened to USD2.1bn in
1Q08. On a positive note, OFW remittances are still growing, and this should
take some pressure off the current account.
Historically, USD/PHP is known to retrace about 45% of large moves, like it did
in 1997/98 and 2000/01. Like these two episodes, the PHP is currently confronting
an uncertain global economy. Assuming that the same 45% retracement takes
place, USD/PHP could extend its rise to 47 before entering into a broad consolidation,
possibly between 41 and 47. If export competitiveness becomes a priority with
the government, the consolidation range could be narrow at 45-47 instead.
USD/PHP
forecast, eop
Latest Prev
Close 44.2 41.2
2Q08 44.5 42.5
3Q08 45.0 41.0
4Q08 47.0 39.0
1Q09 45.0 41.0
2Q09 45.0 41.0
3Q09 43.0 41.0
4Q09 43.0 41.0
BSP o/n call rate
forecast, eop
Latest Prev
Close 5.25 5.00
2Q08 5.25 5.00
3Q08 5.75 5.00
4Q08 6.00 5.00
1Q09 6.00 5.00
2Q09 6.00 5.00
3Q09 6.00 5.00
4Q09 6.00 5.00
Latest close on Jun 11
Prev close on Mar 12
USD/PHP - 45% retracements after big currency moves, before entering into a consolidation
60
55
45% retracement
of 1999-00 rise
50
45
45% retracement
of 1997-98 rise
40
35
30
25
47% retracement of 1993-94 fall
20
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
39

Currencies
Economics – Markets – Strategy
Indian rupee – still sensitive to downside in Indian equities
USD/INR
forecast, eop
Latest Prev
Close 42.7 40.4
2Q08 43.0 41.5
3Q08 43.0 40.5
4Q08 43.5 39.5
1Q09 42.5 40.5
2Q09 42.5 40.6
3Q09 42.0 40.3
4Q09 42.0 40.3
RBI repo rate
forecast, eop
Latest Prev
Close 8.00 7.75
2Q08 8.00 7.75
3Q08 8.25 8.00
4Q08 8.25 8.25
1Q09 8.25 8.25
2Q09 8.25 8.25
3Q09 8.25 8.25
4Q09 8.25 8.25
Latest close on Jun 11
Prev close on Mar 12
The Indian rupee (INR) has transformed from being Asia’s top performing currency
last year to become one of its worst currencies this year. As at Jun 9, the INR has
depreciated 8.0% year-to-date against the USD, in contrast to the full-year gain
of 12.3% posted in 2007. Like it or not, the improving fundamentals responsible
for appreciating the INR in the past few years have weakened in 2008.
The most conspicuous source of INR weakness this year came from capital outflows.
For the first time since 1998, net investments by foreign financial investors or
FIIs turned negative. In the first five months of 2008, net investments fell by
INR118bn, after having doubled to USD809bn in 2007 from an average INR414bn
in the previous three years.
In this regard, we were correct to link the INR’s vulnerability to its weak stock
market, one of this year’s worst performing bourses in Asia. Pressure on the INR
should intensify if the Sensex falls further towards the level of the Dow Jones
Industrial Average. The stock market’s weakness is consistent with headline GDP
growth moderating back towards levels posted in 2005. One area of concern is
industrial production, where growth has decelerated for four consecutive quarters
to 5.7% YoY in 1Q08, after peaking at 12.5% in 1Q07.
Another worry is the unabated rise in oil prices, which is pressurizing both the
trade deficit and inflation. Having surged to 8.24% YoY on May 24 from 3.07%
YoY on Oct 13, WPI inflation has scope to trend higher towards double-digit
levels after the latest fuel price hikes in June. Inflation has scope to increase
political uncertainties if the government’s communist allies decide to withdraw
support ahead of the next general election due in May 2009. Meanwhile, costlier
energy imports are likely to lead to another significant deterioarion in the trade
deficit to USD90bn in calendar 2008 from USD71.3bn the previous year.
That said, we still consider the INR to be a structurally sound currency over the
medium-term. At USD310bn in Mar08, foreign reserves are more than sufficient
to cover total external debt, which last stood at USD201bn in 4Q07. Foreign
direct investments (FDI) have remained strong, and should help to cushion the
foreign portfolio outflows.
The INR has scope to consolidate in a broad range between 40 and 43 after it
returned some gains chalked in the previous 1-2 years. That happened in 2005
during the last US rate hike cycle. On the policy front, the INR is caught between
the twin goals of price stability and restoring competitiveness. Unlike 2005, we
are mindful that the stock market is more vulnerable because of outflows, and
will downgrade the INR if we see FDI weakening as well.
INR has been sensitive to weak Indian stocks
Benchmark stock indices, spot
25000
20000
15000
10000
5000
0
USD/INR
(rhs)
Sensex
(lhs)
02 03 04 05 06 07 08
50
48
46
44
42
40
38
First time since 1998 that witnessed FII outflows
Net inflows from FIIs, INR bn
900
800
700
600
500
400
300
200
100
0
-100
2008 is cumulative Jan-May data
97 98 99 00 01 02 03 04 05 06 07 08
40

Economics – Markets – Strategy
Currencies
Vietnam dong – bears emerge
The VND is under pressure from persistent double-digit inflation and a sharply
widened trade deficit. This is a far cry from the Aug 2007 to Mar 2008 period
when Vietnam was touted as the latest Asian Tiger to follow the path of China
and India. Between 2007 and 2008, the VND has transformed from being one of
Asia’s more promising currency to become Asia’s most worrying exchange rate.
Unlike 2006 and 2007, Vietnam stocks have been depreciating steadily since
4Q07. By early June, the stock market effectively wiped out all gains achieved
during the bull run from Aug 2007 to Mar 2008. As at Jun 9, the Ho Chi Minh
Stock Index fell to 379, its lowest level since Feb 2006.
The deterioration in the merchandise trade deficit has become too large to
ignore. The trade gap totaled USD14.4bn in the first five months of 2008, exceeding
the full-year deficit of USD12.4bn (17.4% of GDP) posted in 2007.
Of course, a large trade deficit does not necessarily imply a balance of payments
crisis. Foreign direct investments (FDI) have also risen and matched the increase
in the trade deficit. Cumulative FDI amounted to USD14.7bn in Jan-May 2008.
Like India, a wider trade deficit did not translate directly into a similarly significant
wider current account (CA) deficit in Vietnam over the past few years, thanks to
an improving services balance and increases in net transfers. That said, the government
has warned that the CA deficit could be as wide as 6.5% of GDP and we expect
a figure closer to 15% of GDP. On a positive note, foreign reserves are still
strong and likely to have exceeded total external debt in 2007.
Nonetheless, there is little room for complacency. Since May, international ratings
agencies have, one after the other, been downgrading the outlook for Vietnam’s
debt ratings to negative. The government must rein in persistent double-digit
inflation before it begins to impact investor confidence and lead to significant
outflows. CPI inflation more-than-tripled to 25.2% YoY in May08 from 7.3% the
same month a year ago. This had led to more labor strikes at foreign companies
clamouring for higher wages to keep up with inflation.
USD/VND
forecast, eop
Latest Prev
Close 16621 --
2Q08 16650 --
3Q08 16740 --
4Q08 16860 --
1Q09 16990 --
2Q09 17120 --
3Q09 17250 --
4Q09 17380 --
SBV prime rate
forecast, eop
Latest Prev
Close 14.00 --
2Q08 14.00 --
3Q08 15.00 --
4Q08 16.00 --
1Q09 16.00 --
2Q09 14.00 --
3Q09 14.00 --
4Q09 14.00 --
Latest close on Jun 11
Prev close on Mar 12
Overall, the rapid deterioration in both the trade deficit and inflation suggests
an overheating economy. Tough measures will be needed to rein in credit expansion
and fiscal spending, as well as reforms to strengthen financial institutions and
capital markets. The VND will also need to depreciate to regain some of the
competitiveness eroded by inflation, as well as to counter the deterioration in
the trade sector. Hence, the government’s decision on Jun 10 to devalue the
VND by 2% and hike interest rates to 14% from 12% should be viewed as the
first steps in the right direction.
VND finally succumbed to falling stocks
1200
1100
1000
900
800
700
600
500
400
300
Ho Chi Minh
stock index
(lhs)
USD/VND
(inverted, rhs)
Jan-06 Jan-07 Jan-08
15800
15900
16000
16100
16200
16300
Not a balance of payments crisis yet
USD bn
40
30
20
10
0
-10
-20
-30
-40
2008 is extrapolated
from Jan-May data
Foreign direct
investment
Current
account
Merchandise
trade balance
01 02 03 04 05 06 07 08
41

Currencies
Economics – Markets – Strategy
Currency forecasts
11-Jun 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09
EUR/usd 1.5553 1.52 1.49 1.46 1.43 1.45 1.46
Fwd 1.54 1.53 1.53 1.52 1.52 1.51
Poll 1.54 1.50 1.46 1.50 1.46 1.41
usd/JPY 106.83 107 108 109 110 108 106
Fwd 107 106 106 105 105 104
Poll 104 105 104 100 103 106
usd/CNY 6.9184 6.80 6.75 6.70 6.65 6.55 6.45
Fwd 6.87 6.77 6.65 6.60 6.52 6.44
Poll 6.79 6.65 6.55 6.45 6.38 6.30
usd/HKD 7.8089 7.83 7.85 7.85 7.85 7.83 7.80
Fwd 7.79 7.78 7.77 7.76 7.75 7.74
Poll 7.80 7.80 7.80 7.78 7.78 7.77
usd/TWD 30.360 30.5 31.0 31.5 32.0 31.5 31.0
Fwd 30.2 30.0 29.8 29.6 29.3 28.9
Poll 30.0 30.0 29.7 29.9 29.6 29.2
usd/KRW 1030 1075 1100 1075 1075 1050 1050
Fwd 1033 1034 1034 1033 1031 1029
Poll 1000 980 975 975 961 947
usd/SGD 1.3707 1.38 1.40 1.42 1.44 1.42 1.40
Fwd 1.37 1.36 1.36 1.35 1.35 1.35
Poll 1.35 1.34 1.33 1.33 1.32 1.30
usd/MYR 3.2700 3.30 3.35 3.40 3.45 3.40 3.35
Fwd 3.28 3.27 3.27 -- -- --
Poll 3.15 3.10 3.08 3.15 3.10 3.05
usd/THB 33.080 33.5 34.0 34.5 34.9 34.1 33.4
Fwd 33.5 33.7 33.8 -- -- --
Poll 31.9 31.2 30.9 32.8 31.9 30.9
usd/IDR 9300 9500 9600 9700 9800 9500 9300
Fwd 9539 9746 9952 -- -- --
Poll 9200 9150 9100 9050 9025 9000
usd/PHP 44.200 45.0 47.0 45.0 45.0 43.0 43.0
Fwd 45.9 46.3 46.1 -- -- --
Poll 42.5 42.1 41.3 42.0 41.4 40.8
usd/INR 42.700 43.0 43.5 42.5 42.5 42.0 42.0
Fwd 43.2 43.4 43.6 44.0 44.1 44.2
Poll 41.2 40.6 40.8 41.9 41.3 40.8
usd/VND 16621 16740 16860 16990 17120 17250 17380
Fwd 18651 19733 20772 -- -- --
Poll 16300 16200 16100 17300 16875 16450
GBP/usd 1.9633 1.94 1.92 1.90 1.88 1.86 1.88
Fwd 1.94 1.92 1.91 1.90 1.90 1.89
Poll 1.96 1.92 1.88 1.87 1.86 1.85
AUD/usd 0.9467 0.94 0.92 0.90 0.88 0.86 0.88
Fwd 0.93 0.92 0.91 0.90 0.89 0.88
Poll 0.94 0.92 0.89 0.88 0.87 0.85
NZD/usd 0.7557 0.75 0.73 0.71 0.69 0.67 0.69
Fwd 0.74 0.73 0.73 0.72 0.72 0.71
Poll 0.75 0.73 0.71 0.67 0.68 0.68
usd/CAD 1.0199 1.03 1.05 1.07 1.09 1.11 1.09
Fwd 1.02 1.02 1.02 1.02 1.02 1.02
Poll 1.03 1.05 1.08 1.07 1.08 1.09
DBS forecasts in bold red. Poll are median forecasts from analysts collated by Bloomberg as at 11 Jun 2008
42

Economics – Markets – Strategy Yield
Yield: Bearish
• US: We believe Treasury yields will rise more than 100bps in the remaining
months of this year. With improving economic growth, inflationary
pressures that may not be temporary, and increasing bond supply, we are
bearish on the US bond market, which we think will have to discount
substantial Fed tightening for 2009
• SG: With the Fed rate cut cycle having come to an end, upward pressures
are building on SGD rates. A rise in US Treasury yields in 2H08 on the back
of more aggressive Fed rate hike expectations is expected to put SGS yields
under upward pressure
• HK: As the HKD remains credibly pegged against the USD, HKD rates continue
to track USD rates. Moreover, as USD/HKD forwards continue to reflect a
HKD appreciation bias, Hibor-Libor spreads continue to be steady
• KR: Stagflation dynamics are keeping the Bank of Korea on hold and the
market guessing whether the next move from the central bank will be up
or down. The market will likely struggle for direction in 3Q08
• TW: Chances are that the CBC’s rate hike cycle is not yet over and that the
central bank will lift the benchmark rediscount rate to 3.875% from 3.5%
over the next three meetings. We expect bond yields to be under upward
pressure in 2H08
• TH: While the Bank of Thailand has kept its policy rate unchanged in 2Q08,
a rate hike scenario has been gaining momentum. Given that the sell-off in
2Q08 has taken yields to levels that reflect a good chance of significantly
tighter monetary policy conditions, the sell-off in front-end yields should
come to an end soon
• ID: Long-end Indonesian Government bonds are a buy. We expect yields to
fall in 2H08 and the curve to steepen, as policy rates are unlikely to rise to
13% again
• PH: Bangko Sentral ng Pilipinas on June 5 lifted its policy rates by 25bps to
rein in inflationary expectations. This is bad news for the bond market and
means yields will remain under upward pressure. A sharp rise from current
levels is however unlikely, given that the bulk of the sell-off in the bond
market has already occurred
• MY: With rate hikes having been discounted at the front end of the yield
curve and investors being better compensated for inflation risks, we believe
yields are unlikely to rise much from current levels
• IN: The direction of gilt yields remains a tough call, but we remain
comfortable with our rate hike forecast. Inflation risks are even more
prominent now after the hike in diesel and petrol prices earlier this month
and the growth outlook is not weak enough to keep the RBI on hold
• CH: Against our expectation, government bond yields continue to trade
sideways as the market refuses to discount the rate hikes we expect. We
think that the market is too complacent about inflation and rate hike risks
YIELD
Jens Lauschke • (65) 6224 2574 • jensjoerg@dbs.com
43

Yield
Economics – Markets – Strategy
US Treasury yields
are likely to rise
sharply
US: Bearish Treasuries
We believe Treasury yields will rise more than 100bps during 2H08. With improving
economic growth, inflationary pressures that may not be temporary, and increasing
bond supply, we are bearish on the US bond market, which we think will have
to discount substantial Fed tightening for 2009.
Much argues for a substantial sell-off in bonds. If the US economy picks up and
credit conditions improve in 2H08 and 2009, the Fed will have to remove the
policy accommodation that is currently in place with Fed Funds at 2% (see the
US economics section for details). We are confident that growth should improve,
thanks to:
a) continued noncyclical core consumption growth
b) relatively strong foreign demand
c) fiscal injections equivalent to 1.75% of GDP now coming on stream
d) a housing sector that will subtract progressively less from growth in the coming
quarters
e) lower interest rates
Moreover, there is the risk of an inflation psychology developing among consumers,
which suggests that even if the economy only grinds forward in the coming
quarters, the Fed might raise rates to prevent inflation from becoming an entrenched
phenomenon embedded in the economy.
Specifically, as growth improves to 2.5-2.75% (saar) in 2H08 and maintains at
this pace in 2009, we expect the Fed to hike Fed Funds by 50bps to 2.5% in 4Q08
and by 175bps to 4.25% in 2009. Fed tightening of this magnitude is not priced
into the yield curve, which means the front end will have to steepen if the
market comes around to the view that policy rates have to rise considerably.
Judging from recent history, 2Y yields could rise to 200bps above Fed Funds (i.e.
to 4%) in 2H08, before the Fed even starts to hike interest rates (Chart 1).
Chart 1: UST 2Y Yield - Fed Funds
%pa
bps
Chart 2: UST 10Y Yield - Fed Funds
%pa
bps
7
300
7
500
6
200
6
400
5
4
3
2
100
0
-100
5
4
3
2
300
200
100
0
1 Fed Funds Target Rate
UST 2Y - Fed Funds (RHS)
0
Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06
-200
-300
1
Fed Funds Target Rate
UST 10Y - Fed Funds (RHS)
0
Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06
-100
-200
Using the current regression relationship between 2Y and 10Y yields as a rough
guide, a rise in the 2Y yield to 200bps above Fed Funds (i.e. 4%) would put 10Y
yields at least 300bps above Fed Funds (i.e. to 5%), implying a flattening of the
44

Economics – Markets – Strategy Yield
Chart 3: 2Y UST Yield - FFR vs 10Y UST Yield - FFR
Chart 4: 10Y UST Yield vs 2Y UST Yield - FFR
Y = 10Y UST Yield - Fed Funds (bps)
350
y = 0.666x + 157.56
300
250
Forecast
200
from 30 Apr 08
150
100
last 60 trading days
50
0
-200 -100 0 100 200 300
X = 2Y UST Yield - Fed Funds (bps)
10Y UST Yield (%pa)
5.50
5.00
4.50
A
Forecast
Current
4.00
B C
A: Jun07 to Dec07
3.50
B: Dec07 to Mar08
C: Mar08 to Currnet
3.00
-200 -150 -100 -50 0 50 100 150 200 250
2Y UST Yield - Fed Funds (bps)
2Y/10Y curve to 100bps from 120bps currently (Charts 2 & 3). While the current
regression relationship based on the last 60 trading days is likely biased towards
low 10Y yields (i.e. the regression line is too flat), a yield level of 5% for the 10Y
yield also looks reasonable on a scatter plot based on the last 250 trading day
(Chart 4).
Singapore: Upward pressures are building on SGD rates
With the Fed rate cut cycle having come to an end, upward pressures are building
on SGD rates. A rise in US Treasury yields in 2H08 on the back of more aggressive
Fed rate hike expectations is expected put SGS yields under upward pressure.
Higher SGS yields are, hence, likely by year end, even if SGD money market
rates remain low until the Fed starts to lift its target for Fed Funds in 4Q08. That
said, SGS yields are unlikely to rise as fast as their US counterparts, resulting in
wider spreads between SGS and UST rates (Chart 5).
In response to the expected flattening in the 2Y/10Y US Treasury curve, the 2Y/
10Y SGS curve should flatten too. Given our expectation that USD/SGD will rise
in the months ahead and reach 1.40 by year-end, there is, in fact, the possibility
that the 2Y/10Y SGS curve flattens relative to the 2Y/10Y UST curve. This is
because trends in the currency markets could entail higher SGD money market
rates.
US Treasury yields
are likely to lead
SGS yields higher
Chart 5: UST/SGS 2Y & 10Y vs Libor-SOR 12M
bps
300
250
200
150
100
50
UST/SGS 2Y Spread
UST/SGS 10Y Spread
Libor 12M - SOR 12M Spread
0
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08
Chart 6: SGS 2/10 Spread vs UST 2/10 Spread
bps
300
250
200
150
100
50
0
-50
SGS 2/10 Spread
UST 2/10 Spread
-100
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
45

Yield
Economics – Markets – Strategy
Hong Kong: Still credibly pegged
As the HKD remains credibly pegged against the USD, HKD rates continue to
track USD rates. Moreover, as USD/HKD forwards continue to reflect a HKD appreciation
bias, Hibor-Libor spreads continue to be steady and a sharp rise in Hibors relative
to Libors is unlikely (Charts 7 & 8).
Chart 7: USD/HKD Spot & Forwards
HKD per 1 USD
7.90
7.85
7.80
7.75
Current
forward path
for USD/HKD
7.70
Jan-06 Jan-07 Jan-08 Jan-09
Chart 8: USD/HKD Spot - 7.75 vs Libor-Hibor 12M
pips
1200
1000
800
600
400
200
USD/HKD Spot - 7.75
Libor 12M -Hibor 12M (RHS)
0
Jan-07 Jul-07 Jan-08
bps
160
140
120
100
80
60
40
20
0
-20
Hence, our outlook for Fed Funds implies that Hibors are likely to rise in 4Q08
and 2009. Moreover, as Treasuries are likely to sell-off sharply in 2H08 in anticipation
of substantial Fed tightening, Exchange Fund Notes too will be under upward
pressure in the coming months. In other words, we expect the notes to continue
to track our rough fair value estimates (defined as UST yield - 12M money market
rates differential) higher (Charts 9 & 10).
Chart 9: EFN 2Y Yield
%pa
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
+50bps
-50bps
2Y EFN Yield
0.5 Fair Value (2Y UST - 12M Libor/Hibor
0.0
May-05 May-06 May-07 May-08
Chart 10: EFN 10Y Yield
%pa
5.5
+50bps
5.0
4.5
4.0
3.5
3.0
-50bps
10Y EFN Yield
2.5
2.0
Fair Value (10Y UST - 12M Libor/Hibor spread)
1.5
May-05 May-06 May-07 May-08
Korea: Rate cuts needed?
Stagflation dynamics are keeping the Bank of Korea on hold and the market
guessing whether the next move from the central bank will be up or down.
Until May the market was leaning towards rate cuts, but non-action and the
absence of any rate cut signal from the BOK at the May 8 monetary policy
46

Economics – Markets – Strategy Yield
Chart 11: Equipment Investment and Inventory
%YoY
25
20
15
10
5
Chart 12: Trends in Bank Lending
KRW tr
450
400
350
300
Household Debt
Loans to Companies
0
-5
-10
Equipment Investment
Inventory
250
200
-15
May-03 May-04 May-05 May-06 May-07
150
Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07
meeting caused a rapid adjustment in expectations. Yields rose sharply to levels
that reflect expectations for tighter policy for the remainder of this year.
While the domestic economy, domestic demand in particular, is exhibiting some
signs of a slowdown, the Bank of Korea kept rates on hold in May as exports
continue to post robust growth and financial institutions’ lending continues to
show a steady increase. (Charts 11 & 12).
We think the BOK will deliver one 25bps rate cut later this year and another one
in 1Q09, but economic conditions have to deteriorate for this to materialize.
With growth unlikely to fall sharply below potential (we expect full year growth
of 4.6% this year, compared to potential of about 4.5%), bank lending still
strong and inflation rising, this is far from being a done deal.
For the bond market the above means that the market will likely struggle for
direction in 3Q08. Market participants now read the BOK as reluctant to cut
rates and it would take significant downside surprises in the data or clear signals
from the Bank of Korea to price rate cuts into the yield curve again. That said,
a continuation of the sell-off is probably less likely than a bond rally, given that
economic momentum is slowing and exports have been and appear to remain
the only key positive. We expect yields to be under downward pressure in 2H08
and the curve to exhibit a weak steepening bias (Chart 13 & 14).
The Korean bond
market will likely
struggle for
direction in the
coming months
Chart 13: 3Y KTB Yield vs 10Y KTB Yield
%pa
6.3
6.0
5.8
5.5
5.3
5.0
4.8
3/10 Spread
10Y KTB Yield
3Y KTB Yield
4.5
Jun-07 Oct-07 Feb-08
bps
40
30
20
10
0
-10
-20
Chart 14: KTB 3Y Yield vs KTB 10Y Yield
KTB 10Y Yield (%pa)
6.25
6.00
5.75
5.50
5.25
5.00
steepening
4.75
Last 100 trading days
Last 10 trading days
4.50
4.50 4.75 5.00 5.25 5.50 5.75 6.00 6.25
KTB 3Y Yield (%pa)
47

Yield
Economics – Markets – Strategy
More rate hikes
from the CBC likely
Taiwan: More rate hikes in the pipeline
Rate hike expectations have been raised in 2Q08 as growth momentum remains
strong and inflation is rising sharply. 1Q08 GDP of 6.1%YoY was balanced, with
domestic demand and net exports contributing 3.2ppt and 2.9ppt respectively
to the headline GDP number. Investment recorded a rebound of 5.8%YoY, while
private consumption stayed stable at 2.1%YoY.
Inflation stood at 3.71%YoY in May and is likely to rise further after Taiwan’s oil
refiners in the same month raised gasoline prices, ending the price freeze since
the second half of last year. The official forecast for 2008 inflation has been
lifted to 3.3% from 2.0%, and the official estimate of GDP now stands at 4.8%,
versus 4.3% previously. We see full-year inflation at 3.4% and full-year GDP at
5.0%.
With inflation risk as the key concern and the CBC projecting growth to stay
near potential this year (close to the 10-year average of 4.3%), policy rates are
likely to be lifted further.
It is likely, therefore, that the CBC’s rate hike cycle is not yet over and that the
central bank will lift the benchmark rediscount rate to 3.875% from 3.5% over
the next three meetings in end June, end September, and end December.
As money market rates, deposit rates and new loans rates are at 2.0-3.0% currently,
further policy rate hikes of 37.5bps in total would only lift the inflation-adjusted
real rates back to zero. Monetary conditions would remain supportive of economic
growth.
Given this outlook for monetary policy, we expect bond yields to be under
upward pressure in 2H08. Front end onshore swaps have already moved higher
to discount further rates hikes.
Chart 15: Rediscount Rate, 3M CP & Onshore Swaps
%pa
4.0
3.5
3.0
2.5
2.0
1.5
Rediscount Rate CP 3M
1.0 TWD IRS 1Y
TWD IRS 2Y
0.5
May-06 Nov-06 May-07 Nov-07 May-08
Chart 16: Rediscount Rate, CP 3M, 2Y & 10Y TWGB
%pa
4.0
3.5
3.0
2.5
2.0
1.5
1.0 Rediscount Rate TWgov 2Y
CP 3M
TWgov 10Y
0.5
Apr-05 Apr-06 Apr-07 Apr-08
The rate hike
scenario has gained
momentum in
Thailand ...
Thailand: Strong economic momentum bolsters case for rate hikes
While the Bank of Thailand has kept its policy rate unchanged in 2Q08, a rate
hike scenario has been gaining momentum. As headline inflation has risen to
6.2%YoY and economic indicators still signal a sustained recovery in domestic
demand (Charts 17 & 18), a string of rate hikes is now priced into the front end
of the Thai yield curve.
Real GDP grew 5.6%QoQ saar in 1Q08 and is up 6% YoY in non-seasonally
adjusted terms. Real private consumption (54% of GDP) growth remained weak,
48

Economics – Markets – Strategy Yield
Chart 17: Inflation
%YoY
8.0
7.0
CPI
Core CPI
6.0
5.0
4.0
3.0
2.0
1.0
0.0
Jun-03 Jun-04 Jun-05 Jun-06 Jun-07
Chart 18: Private Consumption and Investment
%YoY
25
20
15
10
5
0
Private Investment
-5
Private Consumption
-10
Nov-01 Nov-03 Nov-05 Nov-07
but should improve from 3.2% (four quarter average). Real investment (22% of
GDP) growth remained robust at 5.8% (four quarter average) and exports continued
to outpace imports (net exports account for about 15% of GDP).
That means growth momentum has not deteriorated in 1Q08 while inflation
risks have become more prominent, which suggests the central bank should be
more inclined to hike interest rates. We retain our forecast for rate normalization
to begin, starting 4Q08 assuming the political situation remains stable enough
and US recession worries fade. As 2008 growth is still expected to be better than
2007, we think some policy accommodation can be removed. We expect the
central bank to take its key policy rate to 3.75% from 3.25% in 4Q08 and hold at
this rate throughout 2009.
As we had expected the market has moved to reflect the probability of substantial
policy action (Charts 19 & 20). The 2Y yield has risen sharply to 4.5%, or almost
150bps above the policy rate. Spreads are now close to those seen between mid-
2004 and end-2005, when spreads between the policy rate and 2Y yields averaged
90bps.
Given that the sell-off in 2Q08 has taken yields to levels that reflect a good
chance of significantly tighter monetary policy conditions, the sell-off in frontend
yields should be coming to an end. This suggests that bearish flattening
pressure on the 2Y/10Y curve bond curve is likely to give way to steepening
forces. With inflation and political uncertainty rising, we think the curve is
more likely to steepen than flatten.
... and yields are
unlikely to rise
much further in
3Q08
Chart 19: Thgov 2Y - 1-day Repo
%pa
6.0
5.0
4.0
3.0
2.0
1.0
1-day Repo
THgov 2Y - 1-day Repo (RHS)
0.0
Nov-03 Nov-04 Nov-05 Nov-06 Nov-07
bps
200
150
100
50
0
-50
-100
-150
Chart 20: 2Y vs 10Y THgov yield
%pa
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
THgov10Y
THgov2Y
1-day Repo
0.0
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
49

Yield
Economics – Markets – Strategy
With 10Y IDR yields
in the 12-13%
range, we think
government bonds
are a buy
Indonesia: Sell-off is over
With the Indonesian government having raised the price of subsidised fuel by
an average 28.7% in May, market attention is now fixated on the question of
whether this is enough to save the budget from collapsing under the weight of
growing subsidy bills. We reckon it is not, if the price of oil averages more than
$115/barrel in 2H08 (see economics section for details).
Bond investors seem to be sceptical too, judging by the fact that 10Y yields
have entered the 12-13% range, within which the policy rate peaked in 2006,
when the government lifted fuel prices by 126% (Charts 21 & 22). Now, after
the sell-off, there is value at current levels. We don’t expect yields to rise much
above current levels, even if international oil prices rise further and the Indonesian
government is forced to adjust subsidies a second time.
Hence, we think long-end Indonesian Government bonds are a buy. We expect
yields to fall in 2H08 and the curve to steepen, as policy rates are unlikely to
rise to 13% again. We currently think that Bank Indonesia will lift rates to only
9.25% in the coming months and hold at that rate well into 2009.
That said, as the currency outlook is deteriorating with Fed rate hikes likely in
4Q08 and 2009 (see currency section for details), we think that there is the risk
that Indonesian government bonds fail to rally and actually come under fresh
upward pressure.
Chart 21: 10Y IDgov Yield vs Policy Rate
%pa
Chart 22: 2Y IDgov, 10Y IDgov & Spread
%pa
14
bps
400
15
13
12
2/10 Spread (RHS)
2Y IDgov Yield
10Y IDgov Yield
350
300
250
11
10
200
9
7
10Y IDgov Yield
1M SBI
5
Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08
8
6
Nov-06 Feb-07May-07Aug-07Nov-07 Feb-08May-08
150
100
50
0
The Philippines: Rate hikes on the horizon
Bangko Sentral ng Pilipinas on June 5 lifted its policy rates by 25bps, citing
indications that supply-driven inflationary pressures are beginning to feed into
demand. Policy makers are seeing early evidence of second-round effects and
the need to act promptly to rein in inflationary expectations.
Headline CPI inflation in May was up 9.6%YoY, continuing to threaten the BSP’s
inflation targets for 2008 and 2009, which stand at 7.0-9.0% and 4.0-6.0%, respectively.
Rate hike concerns are justified given that headline CPI inflation has risen to
8.3%YoY in April, but we don’t think an aggressive tightening cycle lies ahead
(Chart 23). Real GDP has slowed sharply in 1Q08 to 5.2%YoY from 6.4%YoY in
4Q07 as the economy expanded at only 0.8%QoQ sa in 1Q08. That is among the
slowest since 2001.
50

Economics – Markets – Strategy Yield
Chart 23: 2Y PHP yield vs Headline CPI Inflation
%pa, %YoY
20
18
16
14
12
10
8
6
4
2
CPI
2Y PHgov yield
0
Jan-99 Jan-02 Jan-05 Jan-08
Chart 24: 2Y PHgov & 10Y PHgov - 3M Phibor
10Y Phgov - 3M Phibor (bps)
800
700
600
500
400
300
200
100
0
y = 1.4127x + 113.58
Last 800 trading days
2Y/10Y curve tends to
steepen when 2Y rises
above 3M Phibor
-100
-200
-200 0 200 400 600 800
2Y Phgov - 3M Phibor (bps)
Moreover, while liquidity conditions remain ample, excess reserves continue to
be placed with the BSP, suggesting that there is little risk of overly aggressive
and inflationary bank lending. As the central bank reported in its 1Q08 inflation
report, SDA placements stood at P591 billion in Mar08, up from last year’s level
of P53 billion and total volume of banks’ placements with the BSP under the
RRP window stood at P248 billion in Mar08, down from last year’s level of 307.8,
but still high compared to levels prior to 2005 (Chart 25).The more than tenfold
increase in SDAs followed the policy measures implemented by the BSP in May
last year to rein in strong liquidity growth. Then, trust entities of BSP-supervised
financial institutions were allowed to make placements in the SDA facility.
Given slowing growth, the fact that inflation is mainly due to cost pressures and
that it is unlikely that there will be inflationary bank lending, we think the BSP
will not hike rates aggressively. We expect another three rates hikes of 25bps at
the three coming policy meetings.
This is bad news for the bond market and means yields will remain under upward
pressure. A sharp rise from current levels is, however unlikely, given that the
bulk of the sell-off in the bond market has already occurred (Chart 26). The 2Y/
10Y curve looks flat given the new yield levels, suggesting that steepening is
probably more likely than flattening, unless yields fall sharply relative to money
market rates (Chart 24).
Policy rates are
likely to rise
further in the
Philippines as the
central bank reins
in inflationary
expectations
Chart 25: Outstanding RRPs
PHP bn
350
300
250
200
150
100
50
0
Jan-00 Jan-03 Jan-06
Chart 26: O/N Repo & Rev. Repo vs 2Y & 10Y
%pa
16
14
12
10
8
6
O/N Reverse Repo
O/N Repo
2Y PHgov
10Y PHgov
4
May-05 May-06 May-07 May-08
51

Yield
Economics – Markets – Strategy
MGS yields are
likely to rise
further in the
near-term
Malaysia: Policy risks now clearly towards rate hikes
As we had expected, bond yields rose in 2Q08 as the market moved to reflect and
compensate for inflation risks following comments from the government in May
that it will seek ways to increase fuel prices. Concerns that subsidy adjustments
would stoke inflation and prompt rate hikes sent yields higher (Charts 27 & 28).
MGS yields are likely to rise somewhat further in the near-term, after subsidies
were adjusted earlier this month.
With petrol prices having been raised by 41% and diesel prices 63% higher, our
projections show that headline CPI inflation is expected to rise sharply to about
5.8%YoY in June, which should lift full year inflation to about 4.5%YoY. The
impact on growth will be mixed. Overall growth is expected to moderate to
5.1%YoY for the year, down from our previous forecast of 5.8%YoY.
We now think that policy tightening is needed to anchor inflation expectation
and to prevent second round effects of the price increases. We expect Bank Negara
to hike its policy rate by 50bps to 4% at the next policy meeting in July and then
hold at that rate well into 2009.
With rate hikes being discounted at the front end of the yield curve and investors
being better compensated for inflation risks, we believe yields are unlikely to rise
much further from current levels. In fact, given that we only expect a one-off
adjustment in policy rates, receiving positions in onshore swaps look attractive.
Interestingly, MGS yields have not risen as sharply as swap rates, which suggests
long positions in bonds are not as attractive as receiving positions in swaps. MGS
yields could rise further.
Chart 27: 3Y MGS Yields vs 10Y MGS Yields
%pa
5.5
5.0
4.5
4.0
3.5
3.0
Spread (RHS)
MGS 10Y
MGS 3Y
bps
150
125
100
75
50
25
Chart 28: O/N Policy Rate & Klibor 3M vs MYR IRS
% pa
O/N Policy Rate
5.0
Klibor 3M
MYR IRS 1Y
MYR IRS 2Y
4.5
MYR IRS 3Y
4.0
3.5
3.0
2.5
0
May-05 May-06 May-07 May-08
2.5
May-05 May-06 May-07 May-08
India: Still a rate hike story
The direction of gilt yields remains a tough call, but we remain comfortable with
our rate hike forecast. We expect another rate hike of 25bps in the repo and
reverse repo rates before year end. Inflation risks are even more prominent now
after the hike in diesel and petrol prices earlier this month and the growth outlook
is not weak enough to keep the RBI on hold.
On the Inflation front, WPI inflation stands at a 3.5-year high of 8.1%YoY and is
likely to rise above 9%YoY as the fuel price adjustments should push inflation
higher by 1 percentage point (Chart 29).
52

Economics – Markets – Strategy Yield
Chart 29: WPI
%YoY
10
9
8
7
6
5
4
3
2
1
0
Nov-00 Nov-02 Nov-04 Nov-06
Chart 30: Repo & Reverse Repo vs 2Y & 10Y Gilt Yields
%pa
9.0
8.0
7.0
6.0
5.0
4.0
2Y INgov Yield
10Y INgov Yield
1-day Repo
Reverse Repo
3.0
Apr-05 Apr-06 Apr-07 Apr-08
On the growth front, consumer demand has rebounded strongly and there remains
a robust upward trend in industrial production (the sharp fall in the YoY chg
measure is misleading due to base effects). We expect full year growth to be
8.6%, i.e. near potential. We doubt the higher fuel costs will slow growth in
India. Admittedly, investment spending slowed in 1Q08 but we see this as a
pause in spending on fears of US recession. The rebound in consumption should
lead to a pick up in investment too.
Hence, we maintain our call for one 25bps rate hike in the repo and reverse repo
rates from the Reserve Bank of India before year end and we still think that a
sell-off in bonds is more likely than a rally (Chart 30). Sentiment in the bond
market in 2H08 will continue to be dominated by inflation concerns.
Moreover, supply concerns remain, with the combined centre and state fiscal
deficit currently in excess of 8% of GDP and set to worsen next year. As customs
duty on crude oil and petroleum products and duties on diesel and petrol were
cut earlier this month, the fiscal position is going to worsen by an estimated
INR 230bn. In addition, the remaining petroleum subsidies will mean that the
government has to issue oil bonds worth INR 950bn or 1.7% of GDP.
Lastly, India liberalized external commercial borrowing regulations and eased
limits on foreign investment in domestic government and corporate bonds. The
external commercial borrowing limit was raised to USD 50mn from USD 20mn
earlier. Foreign investment limits in government and corporate bonds have been
raised to USD 5bn and USD 3bn respectively from USD 3.2bn and USD 1.5bn
earlier. These measures are positive for the bond market, but are unlikely to
have a significant effect.
A sell-off in the
Indian gilt market
continues to be
more likely than a
rally
China: Bonds should compensate for rate hike risk
Against our expectation, government bond yields continue to trade sideways as
the market refuses to discount the rate hikes we expect. In other words, we
think that the market is too complacent about inflation and rate hike risks.
Consumer prices were up 8.5%YoY in April, despite the government controlling
prices of gasoline, diesel, jet fuel, coal, power and other materials, and could
stay elevated until end of the year. Should price pressures in the coming months
remain similar to those over the last twelve months and the CPI index rises by
0.6%MoM, YoY inflation will stay around 8% (Chart 31).
Chinese bonds
should compensate
for rate hike risks
53

Yield
Economics – Markets – Strategy
This, combined with the fact that GDP growth remains strong, suggests that
policy risks remain tilted towards tightenig and this risk should be reflected in
swap rates and bond yields. With front end swap rates at 4.49%, the same level
as 3M Shibor, that risk clearly is not priced in (Chart 32). We continue to expect
bond yields to rise. We forecast the 1Y lending rate to be raised by 25bps in
4Q08, 1Q09 and in 2Q09 to 8.28% from 7.47% currently.
Chart 31: Headline CPI Inflation
%YoY
if MoM % changes = 0.6
10.0
Current
8.0
6.0
4.0
2.0
if MoM % changes = 0.4
0.0 36-month average of MoM changes = 0.34
12-month average of MoM changes = 0.60
-2.0
Apr-06 Apr-07 Apr-08 Apr-09
Chart 32: 1Y IRS vs 3M Shibor & 1Y Deposit Rate
%pa
5.0
4.8
4.6
4.4
4.2
4.0
3.8
3.6
3.4
3.2
1Y Deposit Rate
3M Shibor
1Y Onshore IRS (vs 3M Shibor)
3.0
Jul-07 Oct-07 Jan-08 Apr-08
Sources: Data for all charts and tables are from Bloomberg and DBS Research.
54

Economics – Markets – Strategy Yield
Interest rate forecasts
%, eop, govt bond yield for 2Y and 10Y, spread bps
11-Jun-08 3Q08 4Q08 1Q09 2Q09
US Fed Funds 2.00 2.00 2.50 3.25 4.00
3m Libor 2.79 2.60 3.00 3.65 4.30
2Y 2.81 3.59 4.00 4.42 4.66
10Y 4.07 4.60 5.00 5.30 5.40
10Y-2Y 127 101 100 88 74
Japan O/N Call Rate 0.51 0.50 0.50 0.75 0.75
3m Tibor 0.84 0.75 0.75 1.00 1.00
Eurozone Refi Rate 4.00 4.25 4.25 4.25 4.25
3m Euribor 4.96 5.05 4.85 4.65 4.50
Indonesia BI Reference Rate 8.50 9.25 9.25 9.25 9.25
3m Jibor 8.98 9.40 9.40 9.40 9.40
2Y 12.62 11.00 10.50 10.00 10.00
10Y 13.50 12.50 12.00 11.50 11.50
10Y-2Y 88 150 150 150 150
Malaysia O/N Policy Rate 3.50 4.00 4.00 4.00 4.00
3m Klibor 3.66 4.15 4.15 4.15 4.15
3Y 4.04 4.40 4.20 4.00 4.00
10Y 4.46 4.80 4.70 4.60 4.60
10Y-3Y 42 40 50 60 60
Philippines O/N Reverse Repo Rate 5.25 5.75 6.00 6.00 6.00
3m Phibor 6.75 6.75 7.00 6.75 6.75
2Y 8.35 8.50 8.75 8.75 8.75
10Y 9.48 9.50 9.75 9.75 9.75
10Y-2Y 114 100 100 100 100
Singapore .. .. .. .. .. ..
3m Sibor 1.44 1.31 1.52 1.94 2.31
2Y 1.27 1.60 2.20 2.40 2.65
10Y 3.61 3.80 3.90 3.93 4.04
10Y-2Y 234 220 170 153 139
Thailand O/N Repo 3.25 3.25 3.75 3.75 3.75
3m Bibor 3.50 3.45 3.95 3.95 3.95
2Y 4.66 4.70 4.80 4.90 4.90
10Y 5.66 5.90 6.00 6.10 6.10
10Y-2Y 100 120 120 120 120
China 1 yr Lending rate 7.47 7.74 8.01 8.28 8.28
1yr deposit rate 4.14 4.41 4.68 4.95 4.95
2Y 3.72 4.00 4.25 4.25 4.25
10Y 4.27 4.40 4.50 4.50 4.50
10Y-2Y 55 40 25 25 25
Hong Kong .. .. .. .. .. ..
3m Hibor 2.15 1.95 2.35 3.05 3.70
2Y 2.66 3.02 3.69 3.87 4.08
10Y 3.59 4.05 4.45 4.75 4.85
10Y-2Y 93 103 76 88 77
Taiwan Rediscount Rate 3.50 3.75 3.88 3.88 3.88
3m Repo 2.65 2.75 2.88 2.88 2.88
2Y 2.31 2.25 2.50 2.50 2.50
10Y 2.72 2.80 2.90 2.90 3.00
10Y-2Y 42 55 40 40 50
Korea 7d Repo 5.00 5.00 4.75 4.50 4.50
3m CD rate 5.36 5.20 4.95 4.70 4.70
2Y 5.73 5.60 5.00 4.90 4.90
10Y 5.94 5.80 5.30 5.30 5.30
10Y-2Y 21 20 30 40 40
India 1d Repo 7.75 8.25 8.25 8.25 8.25
3m Mibor 8.91 7.80 7.80 7.80 7.80
2Y 8.10 8.40 8.40 8.40 8.40
10Y 8.26 8.50 8.50 8.50 8.50
10Y-2Y 16 10 10 10 10
55

Asian Equity Strategy
Economics – Markets – Strategy
Asian Equity: Between the
devil and the deep blue sea
• Our base case scenario of a very weak first quarter but no recession is
slowly being panned out, but markets have overstated recession fear and
risk appetite remains very low. With US recession risks fading we
recommend a portfolio shift towards more beta
• We expect some volatility in the short term as the shift from US growth
fears to inflation fears is expected to drive up US bond yields and strengthen
the USD. Soaring oil prices adds to these fears. While US growth fears have
somewhat subsided, fear of higher inflation in Asia dampening growth
and driving up interest rates are turning the table around to a US recovery
and Asia slowdown story. However a mild slowdown in Asia need to be
seen in the context of a high base in recent years and still above potential
growth levels for most countries
• In view of new Asia headwinds of higher oil prices, inflation and interest
rates , we now prefer the developed markets of Singapore, Taiwan, Hong
Kong and Korea, where fiscal positions are stronger and downside risks to
economic growth forecasts are comparatively lower. Emerging markets in
ASEAN as well as India run the risks of policy missteps, weak fiscal position
and political uncertainty undermining investors' confidence
• We are overweight in Singapore, Taiwan and China-H; benchmark weight
in Hong Kong and Korea; and underweight in Malaysia, Thailand,
Indonesia, and India
Fig. 1: Regional GDP growth
12
10
8
%
China
India
ASIAN EQUITY
Note: The weightings
which we refer to in
our Equity Strategy
outlook are not
necessarily consistent
with the equity
“weightings” being
used in our Asian
Tactical Asset
Allocation. The latter
refer to specifically
constructed
benchmarks for asset
allocation purposes.
6
4
2
0
Asia (8)
US
Japan
EZ
2003 2004 2005 2006 2007 2008f 2009f
Source: DBS. Asia (8) includes countries of Hong Kong, Singapore, Malaysia, Thailand,
Indonesia, Philippines, Korea and Taiwan. Simple average is taken.
Joanne Goh • (65) 6878 5233 • joannegohsc@dbs.com
56

Economics – Markets – Strategy
Asian Equity Strategy
Mildly positive
We are raising the outlook for Asian equities from
a cautious stance in the second quarter to mildly
positive as it becomes more apparent that the US
will avoid recession.
Risk appetite remains very low as depicted in shrinking
trading volume and foreigners' net sell position
since early 2006. 1Q08 US GDP data is an important
sign that recession fears were overstated; our analysis
also finds that inflation fears might be overstated
this time. Rising oil price remains the biggest risk
right now, but has varying impact on the economies
of Asia.
New fed fund forecast; US non-consensus GDP
growth reiterated
DBS economics maintains its projection of 2% US
GDP growth for 2008 that is implied from first
quarter growth of 0.9%, 1.5 in Q2, 2.5% in Q3
and 2.75% in Q4. Our economist has removed the
last rate cut forecast for the year and added two
rate hikes in 4Q08, and more rate hikes to 4.5%
in 2009 as US interest rate normalisation takes its
course after drastic rate cuts by the Fed in the
past nine months.
Between the devil and the deep blue sea
The implications for Asia equities are that US growth
slowdown will be less than mostly feared but interest
rates are set to rise. We recommend a portfolio
shift towards more beta to growth with a focus
on managing interest rate risk in Asian countries.
Volatility in the short term
In the short term, volatility in the US bond markets
and USD could spill over to the equities market,
as the shift in mindset from growth fears to inflation
fears are driving up US bond yields and strengthening
the USD. Soaring oil prices have added to these
fears. Our view is that inflation fears could be
overstated, just as were recession fears at the beginning
of the year. The Fed rate hikes we have pencilled
in are premised on the rates being normalized
after the pre-emptive cuts in the past 9 months.
Hopeful of a second half recovery
We are hopeful of a second half Asian Equities
market recovery premised on:-
1. US economic growth of c. 2% in the second
half; rapid rate cuts and stimulus package to provide
stability and save the US from drifting into recession;
2. Asian domestic demand should hold up in the
face of external weakness, underpinning economic
and earnings growth in the region;
3. Valuation becoming attractive again after three
years of multiple expansion; and
4. Asia's comparatively stronger growth should
continue to attract funds flow into the region.
Macro environment deviates
The macro environment in Asia envisaged in our
base case scenario in our 2Q strategy, however,
has deviated on three fronts. We now make our
allocation changes in response to lower external
risks and rising concerns on the domestic macro
front.
Inflation overshoot
Firstly, inflation has overshot on the upside. However,
core inflation remains low, whilst higher energy
and food prices are driving headline inflation.
Asian equities will find relief later as headline
inflation starts heading south. While the timing
of when inflation will start coming off is difficult
to predict, consensus expectations of around July
(generally expected due to the year-on year effect)
may be slightly too optimistic, probably by a quarter.
We do not think inflation risks will be extended
beyond next year nor will higher inflation pose a
significant threat to Asia's growth, barring the
unpredictable movement of oil prices. DBS Economics
has raised inflation forecasts for 2008 for most
Asian economies, but growth forecasts remain largely
intact.
Fig. 2: Higher food & energy prices are driving up
inflation
%
200
150
100
50
0
-50
-100
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
Food Commodities
Source: Datastream, IFS
Crude Oil
57

Asian Equity Strategy
Economics – Markets – Strategy
Potential downside risk to growth forecasts?
Simply, if forecast 2008 CPI is subtracted from long
term nominal GDP growth to determine the implied
real GDP growth, 2008 growth forecasts look high
compared to the implied growth forecasts.
Fig. 3: Implied real GDP growth, derived from paring
off 2008 inflation from long term potential nominal
growth
LT potential growth
2008 forecast
(1) (2) (3) (4) (3) - (4)
(%)
China 8.2 3.8 12.3 6.5 5.8 10.0 -4.2
Singapore 5.1 2.2 7.4 6.0 1.4 5.1 -3.7
Indonesia 5.7 5.2 11.3 10.3 1.0 5.9 -4.9
Hong Kong 4.1 3.0 7.3 5.0 2.3 4.7 -2.4
Thailand 4.7 3.2 8.1 6.4 1.7 4.7 -3.0
Korea 4.2 2.8 7.1 3.7 3.4 4.5 -1.1
Taiwan 4.2 2.0 6.2 3.4 2.8 4.1 -1.3
Malaysia 5.3 2.3 7.7 4.5 3.2 5.5 -2.3
India 8.1 4.8 13.2 6.8 6.4 7.7 -1.3
Source: Consensus Economics Inc. for LT growth
forecasts, DBS
Fig. 4: Downside risks spreaded out in all Asia markets.
Countries with stronger fiscal position should have the
ability to pump prime and policy flexibility to manage
risks if needed
% %
12
10
8
6
4
2
0
Indonesia
Real
GDP
Singapore
CPI
China
Nom.
GDP
Thailand
Hong Kong
DBS CPI
forecast
Malaysia
* Implied
GDP
growth
Taiwan
Consens
us GDP
growth
forecast
India
Korea
Downside
risks to
growth
Implied*
Consensus GDP forecast
Difference
Source: Consensus Economics Inc., DBS. * Implied from
long term nominal potential growth minus 2008
inflation forecasts
0
-1
-2
-3
-4
-5
-6
Fig. 5: Table of inflation
2005 2006 2007 2008f 2009f
US 3.3 3.2 2.9 3.5 2.3
Japan -0.3 0.2 0.1 0.8 0.2
Eurozone 2.2 2.2 2.1 3.0 2.1
Indonesia 10.5 13.3 6.3 10.3 7.2
Malaysia 3.1 3.6 2.0 4.5 2.0
Philippines 7.7 6.3 2.8 9.0 4.8
Singapore 0.5 1.0 2.1 6.4 2.8
Thailand 4.5 4.6 2.2 6.4 2.8
China 1.8 1.5 4.8 6.5 4.5
Hong Kong 1.0 2.0 2.0 5.0 4.0
Taiwan 2.3 0.6 1.8 3.4 2.4
Korea 2.8 2.2 2.5 4.6 3.0
India* 4.4 5.4 4.3 6.8 4.9
Source: DBS. Up / down arrows denote revisions made
since last quarter
Fig. 6 : Table of real GDP growth
GDP growth, % YoY
2005 2006 2007 2008f 2009f
US 3.2 3.3 2.2 2.0 2.6
Japan 1.9 2.4 2.0 1.5 2.1
Eurozone 1.6 2.9 2.6 2.0 2.0
Indonesia 5.7 5.5 6.3 6.0 6.3
Malaysia 5.0 5.9 6.3 5.1 6.0
Philippines 4.9 5.4 7.3 5.4 6.0
Singapore 7.3 8.2 7.7 6.0 6.8
Thailand 4.5 5.1 4.8 5.0 4.7
China 10.4 11.1 11.9 10.0 9.0
Hong Kong 7.1 7.0 6.4 5.2 4.7
Taiwan 4.2 4.9 5.7 5.0 5.4
Korea 4.2 5.1 5.0 4.6 5.0
India* 9.0 9.6 9.0 8.6 8.6
Source: DBS. Up / down arrows denote revisions made
since last quarter
Countries with pro-growth policies and strong reserves
and budget balance can afford to pump-prime
the economy to sustain growth, others might not
be able to do that. As such we now prefer the
developed markets of Hong Kong, Singapore, Taiwan,
and Korea, where fiscal positions are stronger and
downside risks to economic growth forecasts are
more benign. Emerging markets in ASEAN are least
favored.
58

Economics – Markets – Strategy
Asian Equity Strategy
Fig. 7: Table of policy rate forecasts
current 3Q08 4Q08 1Q09 2Q09
US 2.00 2.00 2.50 3.25 4.00
Japan 0.50 0.50 0.50 0.75 0.75
Eurozone 4.00 4.25 4.25 4.25 4.25
Indonesia 8.50 9.25 9.25 9.25 9.25
Malaysia 3.50 4.00 4.00 4.00 4.00
Philippines 5.25 5.75 6.00 6.00 6.00
Singapore* 1.44 1.31 1.52 1.94 2.31
Thailand 3.25 3.25 3.75 3.75 3.75
China 7.47 7.47 7.74 8.01 8.28
Hong Kong* 2.15 1.95 2.35 3.05 3.70
Taiwan 3.50 3.75 3.88 3.88 3.88
Korea 5.00 5.00 4.75 4.50 4.50
India 8.00 8.25 8.25 8.25 8.25
Source: DBS. Up / down arrows denote revisions made
since last quarter. First published for 2Q09 figures. * 3-
month interbank rate used. Current as of June 11.
Fig. 8: Table of exchange rate forecasts
current 3Q08 4Q08 1Q09 2Q09
Japan 107 106 107 108 109
Eurozone 1.55 1.52 1.49 1.46 1.43
Indonesia 9,319 9,500 9,600 9,700 9,800
Malaysia 3.27 3.30 3.35 3.40 3.45
Philippines 44.4 45.0 47.0 45.0 45.0
Singapore 1.37 1.38 1.40 1.42 1.44
Thailand 33.1 33.5 34.0 34.5 34.9
China 6.92 6.80 6.75 6.70 6.65
Hong Kong 7.81 7.81 7.83 7.84 7.85
Taiwan 30.4 30.5 31.0 31.5 32.0
Korea 1,025 1,075 1,100 1,075 1,075
India 43.1 43.0 43.5 42.5 42.5
Source: DBS. Up / down arrows denote revisions made
since last quarter. First published for 2Q09 figures.
Current as of June 10.
Grappling with Oil
Having said that, rising inflation particularly from
higher energy prices, will have a varying impact
on the economies in Asia. Countries that are still
subsidizing fuel prices including Indonesia, Malaysia
and India have cut subsidies by 28.7%, 40% and
10%, respectively (average, depending on fuel
category). This does not bode well for the inflation
trend to soften soon in these countries. Interest
rates are likely to rise, whilst fear of social instability
and the potential for further subsidy cuts will
dampen sentiment. This comes at a time when
the political scenes in these countries are becoming
less stable. Indonesia and India will hold their
general elections next year, while Malaysia's ruling
party just lost its 2/3 majority win in the last elections
and political upheaval is budding.
Most importantly, these three countries run large
budget deficits that if left unchecked coupled with
ballooning subsidies because of higher oil prices,
could lead to rating downgrades.
We now have underweight recommendations for
these three countries.
Dollar rebound
Secondly, with the pause in the US monetary easing
cycle, the USD might not weaken as much as in
the first half this year. And some Asian currencies
may find difficulty strengthening. Hence, there are
threats of higher Asian interest rates if currencies
cannot help tame inflation. We have pencilled in
more rate hikes or brought forward the rate hikes
for some.
The only country for which we still have a rate cut
forecast is Korea. Our modelling suggests that a
weaker currency and lower interest rates are positive
drivers for Korea's 12-month forward return. Hence,
in line with a positive outlook to the growth scenario,
we are raising Korea to Neutral from Underweight.
(See section on Korea)
Rising bond yields
Thirdly, bond yields are expected to rise from here
as the bond market starts to price in rate hikes.
We expect the US 10-year bond yield to rise to 5%
from 3.8% currently. The implications for equities
are that equities will be deemed expensive in a
rising interest rate environment, but our stress test
suggests that the bond / earnings yield relationship
is still within the one standard deviation band.
Fig. 9: US / Asia ex-Japan earnings yield ratio - proforma
at US 10-year bond yield = 5%
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
(x)
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
Source: DBS, Datastream, Bloomberg
Equities
expensive
Equities
cheap
59

Asian Equity Strategy
Economics – Markets – Strategy
Fig. 10: Key drivers
Countries Positive drivers Negative drivers
Singapore Valuations are attractive in a historical context. Downgrades High beta, financial services and direct investment growth
already in the price, domestic growth still intact. Less affeced will be affected by global growth slowdown
by inflation; government has ability to pump prime; ongoing
projects should continue to drive investment growth. Interest
rates should rise slower than other countries; demand for
offshore marine servivces remain strong;
Hong Kong
Malaysia
Broad based economic expansion; rising rates in syn with
inflation cycle
Overhang on fuel price subsidy removed; politcal uncertainty
provides opportunity for change; CPO prices stable
Most affected by rise in US interest rates as well as austerity
measures in China
Political uncertainty to delay investment spending with the
withdrawal of fiscal stimulus previously budgetted
Thailand
Weak THB to help exports sector which has been a big
contributor to growth
Higher inflation, interest rates and politic uncertainty to bite
into domestic demand recovery; no end in sight for
Indonesia Coal and energy sector still attracting FDI and in demand Removal of subsidy to affect spending and fear that more
cuts might be needed; inflation to rise above double digit
and interest rates to rise; fear of weakening rupiah
China
Korea
Good growth; strong domestic consumption and demand,
urbanisation and reconstruction needs to sustain high level
gowth
Fiscal stimulus on the way; weak won and interest rate cuts
to help exports sector; exports sector geared to US recovery
Further tightening in fear of overheating; inflation overshoot
Still weak domestic demand and confidence due to financial
strains of falling property prices
Taiwan Improving cross-straits relationship; Tech sector to improve
from US recovery; attractive valuations
India Growth is still forecast to be close to 9% Monetary tightening to cool overrun inflation; twin deficits
means fiscal constraints and weak currency; risks of policy
mis-step compromised by politics
Emerging
ASEAN
Infrastructure needs to sustain investment spending
Overrun inflation, weak currency due to USD rebound, rising
interest rates to tame inflation, political uncertainty adds to
domestic woes; fear of weakening currency augmenting
outflows spiralling to further weakness. Budget constraint on
fiscal spending. High oil prices to affect sentiments and
spending; domestic demand story is questionable now
North Asia
Relatively exports dependent which means better prospects
in a US recovery scenario; inflation rate still below 5% which
are comparatively lower. No urgency to raise rates
Relatively exports dependent
Source: DBS
60

Economics – Markets – Strategy
Asian Equity Strategy
Risk appetite
If the retracement from the high of 4Q 2007 is
due mainly to a loss of risk appetite or a rise in
equity risk premium because of a deterioration
in the external environment, a gradual return to
normalcy would bring markets back to pre-crisis
levels. Our risk appetite assessment model (introduced
in 4Q07) suggests that risk appetite has fallen the
most since September 2007 in Singapore, Hong
Kong and China. But it has indeed improved in
Taiwan. The implications are that all things being
equal, we will see that an improvement in risk
appetite should benefit countries that were most
heavily penalized.
Deteriorating domestic conditions in Thailand and
a rising interest rate environment for Hong Kong
suggests that a return to pre-crisis levels for these
countries is unlikely. Hence, we are downgrading
these two markets. We are upgrading Singapore
because domestic conditions are intact. The current
risk profile and key drivers for each of the markets
are summarised in Fig. 12 and 10.
Fig. 11: Change in implied equity risk premium
Current end 3Q07 Difference
ERPs (%):
Singapore 12.0 5.0 7.0
Hong Kong 6.2 0.4 5.8
China 7.3 1.8 5.5
Malaysia 12.7 9.9 2.8
India 3.6 1.1 2.5
Asia ex-Japan 6.2 3.9 2.3
Indonesia 3.4 1.4 2.0
Thailand 6.5 5.0 1.5
Korea 3.6 2.7 0.9
Taiwan 6.3 8.9 -2.6
Source: DBS calculations
Statistical analysis: Impact of higher oil price, bond
yields and stronger USD on markets and stocks
The impact falls disproportionately on different
sectors in the stocks market. As a statistical test,
we calculate the correlation of weekly changes in
Asia market indices and sectors with changes in
oil prices, bond yields and USD index, using data
from 1990 till present. The correlation coefficient
is probably too low to be significant, but could
be used as a relative comparison. The findings are
summarized below:
Impact on Markets
Fig. 13: Asia indices’ sensitivity to oil price, bond yields
and US$ strength
Top 3 markets
Positively correlated
Oil Bond
yields
US$
strength
Top 3 markets
Negatively correlated
Oil Bond
yields
US$
strength
H-sh STI STI TWI SET H-sh
KLCI KOSPI TWI STI KLCI HSI
Sensex H-sh SET KOSPI TWI KLCI
0.06 0.3 -0.01 -0.05 0.08 -0.11
0.04 0.13 -0.02 -0.01 0.11 -0.1
0.03 0.12 -0.05 0.00 0.11 -0.07
Source: Datastream, DBS calculations
Not surprisingly, the H-share index, which has a
larger composition of commodity and oil stocks,
is positively correlated to oil prices. The perception
of Malaysia as a net exporter of oil also kept the
index relatively positive to oil prices, although it
might have become only a marginal net exporter
in recent years. The presence of plantation stocks
probably explains the link as well. The relatively
higher proportion of energy stocks in Sensex explains
the presence of Sensex among the top 3.
Fig . 12: Current risk profile and sensitivity
Improving Decreasing
ERPs (%): 1 2 3.4 3.6 4 6.2 7.3 10 12 12.7
Singapore 7,487 6,866 6,095 5,993 5,796 4,838 4,431 3,592 3,093 2,938
Hong Kong 37,533 34,432 30,582 30,074 29,088 24,305 22,268 18,078 15,583 14,811
Malaysia 3,009 2,768 2,468 2,428 2,351 1,978 1,818 1,489 1,292 1,231
Thailand 1,248 1,149 1,025 1,008 977 822 756 619 537 512
Indonesia 2,902 2,680 2,402 2,366 2,294 1,944 1,793 1,480 1,291 1,232
China 22,961 21,040 18,655 18,341 17,730 14,766 13,503 10,907 9,362 8,884
Korea 2,257 2,070 1,838 1,807 1,748 1,459 1,335 1,081 930 883
Taiwan 13,118 12,072 10,771 10,600 10,266 8,646 7,954 6,527 5,674 5,409
India 18,813 17,270 15,346 15,092 14,599 12,194 11,166 9,044 7,773 7,379
Asia ex-Japan 928 852 756 744 719 601 551 447 385 365
Source: DBS, Datastream, Bloomberg. Note that the calculations uses a 10-year DDM, with 2008 and 2009 growth
forecasts used (DBSV if covered, consensus otherwise) and long term nominal GDP growth forecasts for the 3rd - 10th
year, terminal P/E of 12x, risk-free rate using 10-year or equivalent domestic bond yield, and average historical payout
ratio. Shaded cells indicate current index levels and the inferred equity risk premium accordingly,
61

Asian Equity Strategy
Economics – Markets – Strategy
The interpretation of rising US bond yields can
be viewed on two fronts - from a rising inflationary
pressure view point, or outlook for a stronger
than expected US growth accompanied by benign
inflation fears. In view of this we believe the
positive impact of rising bond yields on the Singapore
market makes the most sense as Singapore interest
rates do not necessarily move in tandem with
the US as it has a managed currency policy. A
more positive outlook for US and global growth
should bode well for Singapore stocks.
The STI is also least impacted by a strong USD,
probably due to a relatively larger portion (vs.
the rest of the region) of USD earnings from the
offshore marine sector and SIA. Moreover, the
SGD is pegged to a basket of currencies that includes
the USD. The SGD will weaken less than the rest
of the region when the USD strengthens.
The negative correlation can be analysed from
a top down view. Impact of rising oil prices are
stronger in the TWI, STI and KOSPI, which all
seem to be industrial nations that rely heavily
on oil imports. Thus, profit margins will be impacted
by higher oil prices. Rising bond yield impact is
greater for the SET and KLCI, which are so termed
as "emerging" markets where currencies (and hence
foreign fund outflow) are vulnerable during periods
of rising yields and volatility. The interpretation
of the impact of a strong USD is interesting. One,
they are markets which currencies are pegged
(CNY and MYR) at some period in time. If the
USD weakness is associated with stronger commodity
prices, then it suggests a reason for the H-shares
and the KLCI to be negatively impacted by a
strong USD.
Impact on Sectors
Fig. 14: Asia ex-Japan sector indices’ sensitivity to oil
price, bond yields and US$ strength
Top 3 sectors
Positively correlated
Oil Bond
yields
US$
strength
Oil/Eq
Svs/Dst
Aero/D
efence
Consu
mer
Gds
Basic
Mats
S/W &
Comp Svs
Tch H/W &
Eq
Top 3 sectors
Negatively correlated
Oil Bond
yields
US$
strength
Tch
H/W & Eqt Ivst
Eq Ins
Elt ro/El H/C Eq
ec Eq & Svs
Life Fd &
Insura Drug
nce Rtl
Mining
Gen
Retailers
Tobacc Auto & Personal
o Part s Goods
Utilities
0.2 0.18 -0.02 -0.04 -0.03 -0.15
0.1 0.17 -0.03 -0.01 0.06 -0.15
0.08 0.16 -0.04 -0.01 0.06 -0.15
Source: Datastream, DBS calculations
Direct links can be found with the oil & gas services
sector, which benefits from rising oil prices. The
tech sector, which are normally USD earners will
also benefit from a strong USD. The negative impact
on margins for manufacturers are evidenced in their
negative impact on oil.
Where higher oil prices coincide with strong economic
growth and low unemployment - there will be structural
shifts due to a stronger desire to live nearer to town
or residential areas with convenient public transport.
This should support property prices in Singapore
and Hong Kong. Meanwhile, with the removal of
fuel price subsidies, Malaysians might consider moving
closer to cities rather than drive 2 hours between
work and office. Governments, such as in Malaysia
and Thailand, will also be encouraged to build better
mass transportation infrastructure.
In the bond market, expectations of rising bond
yields should attract flow of funds from the bond
markets to the equities market.
62

Economics – Markets – Strategy
Asian Equity Strategy
Country asset allocation recommendations and
changes
Overweight markets: China-H, Taiwan, Singapore
Underweight markets: Malaysia, India, Thailand,
Indonesia
Neutral markets: Hong Kong, Korea
Singapore: Upgrade to Overweight from Benchmarkweight
Singapore remains the cheapest market in the region,
based on the number of standard deviation away
from historical average of consensus 12-month forward
P/E (see Fig. 15). There was a lot of uncertainty in
the 'E', specifically fear of more downgrades, but
that has been largely priced in. Consensus now
expects negative earnings growth for 2008 instead
of 4% growth early this year, and 10% in September.
1Q08 results were mixed but generally met expectations.
Fig. 15: Regional markets' 12m fwd P/E: No. of standard
deviation away from average - Singapore is the cheapest
market based on historical trend
Singapore
Taiwan
Malaysia
Thailand
Indonesia
AXJ
Korea
China 'H'
Hong Kong
India
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5
Cheap
Expensive
Source: Datastream, Bloomberg, DBS calculations. Average
and standard deviations from 1993 - present.
Going forward we expect the Singapore economy
to experience a modest slowdown y-o-y in 2Q and
3Q before recovering in the 4Q. Engines of growth
should remain in services and construction, refinery
and offshore marine sectors.
Inflation should come off in the next few months
as year-on-year effect of the GST hikes in July last
year diminish. However price level should remain
elevated and continue to hurt consumer spending.
The moderation in the GDP we expected is in private
consumption. While high inflation will slow private
spending, we believe the strong reserves and social
fiscal balance will be a safety net for the needy
Fig. 16: Singapore earnings growth downgraded
20
15
10
5
0
-5
-10
%
2009 earnings
growth
2008 earnings
growth
Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08
Source: IBES, DBS calculations
and less of a social concern for Singapore.
The impact of macro changes on Singapore equities
should be minimal in our view, and selective on
sectors that are sensitive to such changes. We now
forecast higher bond yields with a flattening yield
curve and a stronger USD.
Singapore bond yields have risen in recent weeks
in tandem with US bond yields. Recently, an extraordinary
case of poor auction response to Singapore 10-
year treasury bonds lifted yields by 100bps. With
our new US Fed funds forecast (50bps hikes in 4Q08
and 75bps in 1Q09) we expect the Singapore long
bond yields to rise another 50bps by year end and
35bps in 1Q09, taking bond yields from 3.4% currently
to 4.15%. Among stocks under our coverage, 48%
of them are offering more than 3.4% dividend
yield, and 40% more than 4.15%. But investing
for dividends may not be an appropriate strategy
in a rising bond yield environment.
We expect the USD to strengthen as the Fed easing
Fig. 17: Singapore exchange and interest rates
forecasts
(% )
Fed
funds
3m
SIBOR
12m
SIBOR
SGS
2Y
SGS
10Y
SGD /
USD
current 2.00 1.36 1.91 1.24 3.64 1.37
3Q08 2.00 1.31 2.06 1.60 3.80 1.38
4Q08 2.50 1.52 2.27 2.22 3.90 1.40
1Q09 3.25 1.94 2.69 2.40 3.93 1.42
2Q09 4.00 2.31 2.81 2.65 4.04 1.44
3Q09 4.50 2.67 3.02 2.66 3.92 1.42
4Q09 4.50 2.64 2.89 2.42 3.79 1.40
Source: DBS
63

Asian Equity Strategy
Economics – Markets – Strategy
cycle comes to an end followed by rapid tightening
to normalize interest rates.
Fig. 19: Singapore GDP growth and inflation
20 %
%
10
We summarise the top and bottom three sectors
15
GDP growth (L)
8
Fig. 18: Singapore sector indices’ sensitivity to oil price,
bond yields and US$ strength
10
6
Top 3 sectors
Positively correlated
Oil Bond
yields
US$
strength
Top 3 sectors
Negatively correlated
Oil Bond
yields
US$
strength
5
0
4
2
Oil/Eq
Svs/Dst
Eqt Ivst
Ins
Mining
Persona
l Goods Eqt Ivst Ins
Aero/D
efence
Mining
Fd & Drug
Rt l
Ind. Met &
Mines
Inds
Eng
M edia
Lif e
Insuran
ce
Mobile
T/Cm
H/C Eq
& Svs
Inds
Eng
Mining
Oil/Eq
Svs/Dst
Con & Mat
0.2 0.26 0.10 -0.05 0.00 -0.26
0.14 0.21 0.04 -0.04 0.06 -0.18
0.11 0.21 0.04 -0.03 0.07 -0.16
Source: Datastream, DBS calculations
in Singapore where performances are highly or
least correlated to (i) rising oil prices, (ii) bond
yields, and (iii) stronger USD.
The conviction calls are to raise weighting for offshore
marine sector, and reduce for Telcos. Selective investment
trusts in USD earnings should benefit from the
dollar strength.
We favor the property sector as an inflation hedge.
While we believe physical property prices has room
to fall 20% on average due to the spike last year,
property stocks are trading at 30% discount to
their RNAVs, which imply property prices could
drop 50%. However, we believe this is unlikely,
and would happen only during an economic downturn.
Real interest rates in Singapore remain in negative
territory, and economic growth is still expected
to stay healthy with a relatively tight employment
-5
-10
90 92 94 96 98 00 02 04 06 08
Source: CEIC
Fig. 20: Singapore real rates vs property prices
Index
200
Inflation rate (R)
Source: CEIC. Real rates using 3-month SIBOR minus CPI
inflation
Fig. 21 : Singapore unemployment rate vs wage growth
16
12
180
160
140
120
100
8
80
60
40
20
0
-6
90 92 94 96 98 00 02 04 06 08
%
Property Price Index (L)
%
Real rates (R)
0
-2
8
6
4
2
0
-2
-4
4
0
-4
-8
96 97 98 99 00 01 02 03 04 05 06 07
Unemployment rate
Source: CEIC
Wage growth
64

Economics – Markets – Strategy
Asian Equity Strategy
Fig. 22: Singapore property / banks relative performance
vs inflation rate
Index %
160
8
140
120
100
80
60
40
20
0
90 92 94 96 98 00 02 04 06 08
Property / Banks relative performance (L)
Inflation (R)
Source: DBS, Datastream, Bloomberg
market at 1.8% unemployment rate. Reflation should
still be on track if economic growth remains strong
and under a negative interest rate environment.
Korea: Upgrade to Neutral from Underweight
Korea is raised to Neutral following our expectations
for a weaker won and forecast for cuts in Korean
policy rates. Moreover, with the weaker-than-expected
1Q GDP growth, growth fears has intensified among
policy makers. And the new government could be
rolling out fiscal stimulus, including rate cuts to
bolster domestic demand. We still think the "747"
economic pledge is ambitious, but the Korean government
did lower growth potential to 6% from 7%. The
new government should be working towards achieving
this goal while continuing policy efforts to boost
growth. Emphasis will be placed on revitalizing investments
and domestic consumption, reinforcing competitiveness,
and discovering new growth engines. Tax cuts and
expansion of tax deductions, regulatory reforms and
innovation of public companies, stabilising interest
rates and exchange rates and support to boost exporters'
competitiveness and stabilise current account balances
are in the action plan for 2008.
7
6
5
4
3
2
1
-
(1)
(2)
Fig. 23: Singapore / Hong Kong financials relative
performance vs Fed funds rate
% %
80
6
60
40
20
0
-20
-40
0
01 02 03 04 05 06 07 08
Singapore / Hong Kong Financial sector relative performance
yoy%
Fed funds rate (RHS)
Source: DBS, Datastream, Bloomberg
Fig. 24: Singapore vs Hong Kong residential property
price index
Index
450
400
350
300
250
200
150
100
50
90 92 94 96 98 00 02 04 06 08
Singapore
Hong Kong
Source: DBS, Datastream, Bloomberg
5
4
3
2
1
Hong Kong: Downgrade to Benchmark-weight from
Overweight
We have less preference for Hong Kong now because
of its sensitivity to US interest rates, which are expected
to rise from 4Q08 onwards. Since the Fed started
to cut rates in August 2007, Hong Kong financials
65

Asian Equity Strategy
Economics – Markets – Strategy
have out-performed Singapore financials. We believe
this will reverse as soon as the Fed starts to hike
rates.
Malaysia: Downgrade to Underweight from Benchmarkweight
Malaysia is downgraded due to its "safe haven"
qualities - it should outperform in a low risk appetite
environment but underperforms when risk appetite
is rising. Its safe haven status is mainly derived
from comparatively lower foreign participation
in its market, and hence, less foreign selling against
a backdrop of risk aversion. The market will need
support from local investors.
Political tension in Malaysia has escalated following
the loss of 2/3 majority by the ruling party. The
current PM is under pressure from his own UMNO
party to step down, while the opposition party
claims that it has potentially enough defectors from
UMNO to secure a majority in parliament. Regardless
of the outcome, we believe the market will be
nervous in the near term and investor sentiment
will be muted until the situation is resolved.
Local sentiment has also taken another beating
now that fuel price subsidy has been cut. We expect
inflation and interest rates to rise in the near term.
The economy grew at a robust rate of 7.1% y-o-y
in Q108. Effects of pump priming from last year
have boosted government spending and private
consumption, but weaker growth was registered
in investments. We expect a slowdown in investment
spending as political uncertainty looms. Private
consumption should also be dampened by higher
fuel prices. We downgrade 2008 GDP growth to
5.2% from 5.8%.
Thailand: Downgrade to Underweight
We downgrade Thailand to Underweight on the
back of falling consumer confidence.
Thailand's 1Q GDP growth was below our expectations.
Specifically private consumption and investment
appears to have contracted on a quarterly basis.
Domestic demand recovery were milder than we
had expected. Our economist has revised down
economic growth forecasts to 5.0% from 5.6% for
2008, and 4.7% from 5.2% for 2009.
Runaway inflation has also become less manageable
in Thailand now. Full year inflation has been raised
to 6.4%. Although this was caused mainly by food
inflation, the government has allowed some local
utilities such as transportation and utilities to raise
prices. A few local banks had also raised lending
rates recently. Our forecast calls for a 50bps hike
in policy rates in 4Q08, and a rising interest rate
environment is not conducive for P/E expansion,
according to the statistical model by our Thai Research
team.
With higher inflation and a deteriorating political
situation, we do not expect consumer confidence
to continue to rise. Indeed, the latest set of consumer
confidence data saw its first dip after 5 consecutive
months of expansion since the elections in December.
Our SET index target is now revised down to 840.
Indonesia: Downgrade to underweight
We also downgrade Indonesia to Underweight
as inflationary pressure mounts and the pressure
to cut fuel subsidy has become more intense. Although
the market has largely priced in the recent fuel
hike, we believe that the market might not have
priced in for more fuel hikes, which is quite possible
if oil price keeps rising. On the macro front, we
believe inflation and interest rate will overshoot.
We are selectively overweight in the coal and energy
sector.
China 'H': Maintain overweight
We are maintaining our overweight position for
China 'H' shares. China's flexible policy options
in managing and balancing inflation and overheating
risks are commendable in our view, and are less
likely to produce unexpected shocks like runaway
inflation or a severe downturn in the economy
from aggressive tightening measures. In our assessment
of country allocation, policy flexibility is a key
criteria in times when Asian markets are facing
inflationary and external weakness headwinds.
We expect inflation to stay high in the near term,
contributed mainly by food inflation which is due
to agricultural supply and transportation disruption
in the snowstorm and earthquake hit areas. Other
than that, a lot of domestic prices, primarily fuel
prices and transportation charges remain largely
subsidized and have been stable. Recent developments
in other Asian countries when they removed oil
price subsidy is causing concern for China if it
were to lift its subsidy program soon in view of
the rising oil prices. While it is in one of the long
term plans to liberalise prices of basic items we
believe it will be delayed until inflationary pressures
subside. Even so, the large reserves and budget
surplus position should still be comfortable for
China to do that, notwithstanding the huge post-
66

Economics – Markets – Strategy
Asian Equity Strategy
earth quake reconstruction costs. The restructuring
of the telecom industry is a sign that its many
de-regulation plans remain on track.
Economic growth is broadly in line with government
plans to maintain domestic demand growth. Retail
sales and fixed asset investment growth remain
strong, lending support to our domestic story.
Manufacturing and exports are showing signs of
slowdown as external demand slows, and administrative
measures to remove export tax rebates impacted
exporters, and lesser value-add industries that China
wanted to phase out or needed consolidation.
All in all, it suggests China should be moving
towards a soft landing in terms of inflation and
growth. We believe tightening measures should
still be on the cards, such as interest rate hikes,
increase in reserve requirement ratio and currency
appreciation. But the pace will be slower than
last year.
The broad macro and policy trend is supportive
of H-shares in our view. And we should be less
concerned about tightening measures, but more
on administrative measures targeted at selective
sectors.
Taiwan: Maintain Overweight
We are maintaining our overweight position for
Taiwan as domestic demand growth remains on
track, confirmed by Q108 GDP data. Both domestic
demand and net exports contributed 3.2ppt and
2.9ppt, respectively, to overall growth of 6.1%
y-o-y. Investments rebounded with 5.8% growth,
and we expect a sustained recovery in investment
in 2H08 on the back of supportive policy stimulus
measures. Cross-straits talks has also been progressing
smoothly.
The recent lifting of the temporary control on
oil price should not be taken out of context as
the freeze in hikes was temporary. However, like
many other Asian countries, inflation risks remain
the key concern due to higher food and energy
prices. With better growth prospects, we believe
Taiwan has the capacity to raise rates by 37.5bps,
which will only lift inflation-adjusted real rates
back to the zero level. Monetary conditions should
remain supportive of economic growth.
The outperforming sectors in Taiwan were domestic
demand sectors including banks, insurance and
chemicals, while the electronics sector underperformed.
We expect the domestic sector to outperform but
a gradual recovery in the US should bode well
for the electronics sector. Valuations in the electronics
sector are at a discount to the market.
Fig. 25: Table of performance and valuations for key
sectors in Taiwan
12m fwd P/E (x)
12m fwd
Performance (% )
Avg Std. No. of DY Growth
Sector 3m YTD Current PE Dev. SD. (% ) (% )
Cons. Discre -1.4 0.6 15.0 11.7 2.3 1.4 2.1 7.5
Cons. Staples -3.4 3.9 22.3 16.9 2.7 2.0 2.9 150.5
Energy 0.8 -6.2 16.2 12.6 1.9 1.9 4.7 -14.8
Financials -1.0 20.2 16.9 14.0 1.8 1.5 2.4 35.5
Industrials -4.6 9.8 16.4 12.0 2.6 1.7 2.5 2.4
IT 2.0 -8.5 13.1 15.7 4.7 -0.6 3.1 10.3
Materials -3.1 0.3 11.3 11.0 2.4 0.1 5.2 1.2
Telcos -4.3 13.3 14.3 11.1 2.0 1.6 2.3 13.6
MSCI Taiwan 0.0 -1.4 13.5 13.9 2.9 -0.2 3.2 10.9
NTD 0.2 6.9
Source: IBES, Datastream, Bloomberg
India (Maintain Underweight)
We are maintaining our underweight stance for
India as higher inflation has now become a very
sensitive issue in Indian politics. While high inflation
and calls for more policy tightening are the general
phenomenon among Asian countries, the issue is
complicated in India especially in light of upcoming
elections in 2009.
While runaway inflation is a main threat to overheating
risks, the lack of flexible policy options will make
it difficult for India to manage it wisely; this is
evidenced in the policy mis-steps in the last few
months, including the curb on foreign flows, volatile
exchange rates, the hiking of interest rates of sorts,
and the recent call for curbs on futures contracts.
India's current account deficit is expected to widen
as a weaker INR and higher import prices drive up
import costs, and slower capital inflow and exports
due to the weaker external environment reduce
inflows. That should raise the red flag on its twin
deficit position. India recently hiked fuel price by
10% on average, hopefully to help reduce the deficit.
But this means that inflation will run high in the
near term.
With a stronger USD view now and a slowdown
in capital inflow, we have turned cautious on the
INR. With so much uncertainty surrounding its monetary
policies, we believe India equities are unlikely to
outperform.
Our economist believes that growth is still on track
to reach 8.6% this year despite concerns about the
slower exports and industrial production in recent
months. With that in mind, we may review India
again after the threat of higher inflation and policy
mistakes subside. For India to move in the right
direction, we need to see confidence in policy directions
without being compromised by political pressure.
67

Asian Equity Strategy
Economics – Markets – Strategy
Index targets, returns, key trades and risks
We continue to look for a second half recovery
in our index targets. US growth fears have subsided
and short term volatility from runaway inflation
are overshadowing our targeted returns towards
the year end. India’s underweight needs to be
taken into the context of its relatively high volatility;
and Hong Kong our preference for Chinese stocks
listed in Hong Kong . Key risks to our targets remain
with the uncertainty in the US financial crisis and
higher oil prices.
We also present key trade ideas within each of
the countries.
Fig. 26: Index targets and key trades
10-Jun %
Current Target Target
Level 2008 Return Key trade ideas
Taiwan 8370 11000 31.4 Domestic demand recovery and cheap Tech valuations on US recovery
H-share 12790 16000 25.1 Potential liberalisation of energy price to benefit petroleum and power sector
Hong Kong 23376 28000 19.8 HK office sector
India 14889 17500 17.5 Infrastructure
Singapore 3033 3450 13.7 Offshore marine, property, hotels
Korea 1774 1950 9.9 Fiscal stimulus for domestic recovery and exports sector
Indonesia 2374 2600 9.5 Coal and plantations
Thailand 792 840 6.1 Exports and defensive
Malaysia 1231 1200 -2.5 Plantations, oil & gas
Asia ex-Japan* 585 694 18.6
Source: DBS
68

Economics – Markets – Strategy
Asian Equity Strategy
This page is intentionally left blank
69

Economics: China
Economics – Markets – Strategy
CN: Re-thinking CNY
appreciation
• Evidence since Jul 21, 2005 suggests appreciation of the CNY has neither
curbed the trade surplus nor tamed inflation. On the contrary, it has
complicated the management of monetary policy. Appreciation has not
only invited more hot capital inflows, but encouraged the growth of foreign
currency loans
• It is difficult to control lending without raising the cost of capital amidst
an inflationary environment. Higher reserve requirement ratios and the
imposition of a credit quota have not controlled loan growth
• In light of our upward revision on Fed funds rate and a 6.5% 2008 inflation
forecast for China, we now expect benchmark lending rate hikes (of 27bps
each) in 4Q08, 1Q09 and 2Q09. Should this happen, the pace of CNY
appreciation must be slowed down sufficiently to around 3%-4% in 2009
to reverse the ‘appreciation expectation factor’
• While this may be unappealing to the market now, the risk of not changing
the policy mix soon would inevitably lead to more aggressive rate hikes in
the future
CHINA
Exports to the US
and EU have been
declining
Negative income shock hurts exports more than a strengthening CNY
There is little evidence to suggest that the narrowing in China’s trade surplus so
far this year is attributable the appreciation of the CNY. While a strong currency
– on top of rising material and labor costs – have probably hurt exporters, most
of the pain has probably come from the global slowdown.
Exports to the US and EU
have been declining (Chart
Chart 1: China exports by destination
1). The Asian financial crisis % YoY, 3mma
70
in 1998 and the bursting
Asia EU USA
of the ‘tech bubble’ in 2000/
01 demonstrated that China’s
exports suffer when its
60
50
trading partners experience
economic downturns. For 40
instance, China’s export
growth dropped to 0.5% 30
in 1998 and 7.0% in 2001
from 21.0% in 1997 and
28.0% in 2000 – suggesting
that a ‘negative income
20
10
shock’ could be an effective 0
tool to curb China’s trade Apr-00
surplus.
Apr-02 Apr-04 Apr-06 Apr-08
Chris Leung • (852) 3668 5694 • chrisleung@dbs.com
70

Economics – Markets – Strategy
Economics: China
There is considerable academic evidence that the rising value of the CNY tends
to reduce imports rather than to increase them. Econometric estimation of China’s
import elasticity always results in a ‘negative’ sign in studies from organizations
like the World Bank, the IMF and the BIS. These studies reflect the dominance of
‘processing imports’ included within China’s total imports (more than 50% in
2007) as well as the ongoing vertical integration with the rest of Asia. So tradable
goods produced by Asian economies complement China’s exports to a greater
extent than substitutes. Put simply, if exports decline due to a strengthening
CNY, this will be counteracted by a corresponding reduction in imports.
CNY appreciation
tends to reduce
imports, rather
than to increase
them
Does CNY appreciation slow inflation?
The claim that inflation can be tamed through currency appreciation is increasingly
unconvincing. Headline CPI averaged 8.0% YoY in 1Q08, up significantly from
2.7% in 1Q07. Both inflation indices, CPI and PPI, have shown highs of 8.5%
YoY and 8.1% YoY respectively in Apr 2008 despite the faster pace of currency
growth (Chart 2). Indeed, evidence suggests little relationship between them
since Jul 21, 2005. NEER shows that CNY only grew 5% between Jul 2005 and Apr
2008. In real effective exchange rate or REER terms the figure is around 9%
(Chart 3).
Chart 2: Inflation
% YoY
11
CPI
9
7
PPI
5
3
1
-1
-3
-5
Latest: Apr08
-7
Oct-99 Feb-01 Jun-02 Oct-03 Feb-05 Jun-06 Oct-07
Chart 3: CNY REER
Indexed 2000=100
125
120
115
110
109
105
100
95
90
85
80
75
1990 1993 1996 1999 2002 2005 2008
Food and energy prices are still the wild cards
It remains unclear, however, whether inflationary pressures will result in the CPI
falling below 5% YoY in 2H08 from 8% in 1H08. At this time, many economists
predict that prices will start to stabilize in 2H08, basing their arguments on the
‘high-base’ effect carried over from 2H07. However, the Sichuan earthquake
tragedy may put upward pressure on food prices over the next few months as
pork, rice, wheat and corn account for 10.4%, 7.3%, 4.2% and 3.5% respectively
of the nation’s gross output.
Even if consumer inflation stabilizes, the currency can’t do much until food
supplies return to normal. A stronger CNY will not help to lower food prices
when shortages are due to domestic factors. CPI-based inflation in 2H08 looks
set to range within 6.0%-7.0% YoY compared with 8% in 1H08. And inflation
for the whole of 2008 could be at least 6% YoY - much higher than the official
projection of 4.8%.
Even if CPI
stabilizes,
normalization of
food supplies will
take more credit
than the currency
factor
71

Economics: China
Economics – Markets – Strategy
Meanwhile, oil prices have risen
to USD135/barrel. Crude oil
prices in China are nearly three
times more than in 1981 (even
after adjusting for inflation)
and demand continues to
increase (Chart 4).
While a strengthening CNY
will help to alleviate the rising
costs of oil imports, demand
will remain strong if domestic
prices continue to be distorted
by state subsidies. This, will,
in turn, prompt the government
to import more, sustaining oil
demand and prices, which then
leads to calls for a stronger
currency again. A classic vicious
circle.
Chart 4: Growing trade deficit of oil
USD bn
-
(5)
(10)
(15)
(20)
(25)
(30)
(35)
Trade deficit of crude petroleum oil (LHS)
Brent (RHS)
% YoY
70
-10
-20
1Q05 4Q05 3Q06 2Q07 1Q08
60
50
40
30
20
10
0
Persistent currency
appreciation led to
capital inflows and
encouraged foreign
currency borrowing
Interest rate policy is crippled by the strengthening CNY
Persistent currency appreciation has enticed ‘hot capital’ to flow into China.
Foreign currency reserves jumped from USD403bn in 2003 to USD1.53trn in 2007,
representing a near four-fold increase in four years. Yet the reserve requirement
ratio (RRR) only began to increase more frequently in 2007 (Table 1). Meanwhile
in 1Q08, foreign reserves shot up by USD159bn to USD1.68trn, exceeding the
sum of both trade surplus and actual utilized foreign direct investment by a
whopping USD85bn.
As a result, the persistent upward pressure on domestic money supply prompts
the People’s Bank of China (PBOC) to continue raising the reserve requirement
Table 1: China's monetary measures
Announced: 1Y lending rate 1Y deposit rate Reserve requirement
8-Jun-08 -- -- -- -- +1.0% 17.5%
12-May-08 -- -- -- -- +0.5% 16.5%
16-Apr-08 -- -- -- -- +0.5% 16.0%
18-Mar-08 -- -- -- -- +0.5% 15.5%
16-Jan-08 -- -- -- -- +0.5% 15.0%
20-Dec-07 +27 bps 7.47% +27 bps 4.14% -- --
08-Dec-07 -- -- -- -- +1.0% 14.5%
10-Nov-07 -- -- -- -- +0.5% 13.5%
13-Oct-07 -- -- -- -- +0.5% 13.0%
14-Sep-07 +27 bps 7.29% +27 bps 3.87% -- --
06-Sep-07 -- -- -- -- +0.5% 12.5%
21-Aug-07 +27 bps 7.02% +27 bps 3.60% -- --
30-Jul-07 -- -- -- -- +0.5% 12.0%
20-Jul-07 +27 bps 6.84% +27 bps 3.33% -- --
18-May-07 +18 bps 6.57% +27 bps 3.06% +0.5% 11.5%
29-Apr-07 -- -- -- -- +0.5% 11.0%
05-Apr-07 -- -- -- -- +0.5% 10.5%
17-Mar-07 +27bps 6.39% +27 bps 2.79% -- --
16-Feb-07 -- -- -- -- +0.5% 10.0%
05-Jan-07 -- -- -- -- +0.5% 9.5%
03-Nov-06 -- -- -- -- +0.5% 9.0%
18-Aug-06 +27 bps 6.12% +27 bps 2.52% -- --
21-Jul-06 -- -- -- -- +0.5% 8.5%
27-Apr-06 +27 bps 5.85% +27 bps 2.25% -- --
72

Economics – Markets – Strategy
Economics: China
ratio (RRR) to mop-up excessive liquidity, despite the tragedy in Sichuan. Other
than those banks operating in the vicinity of the epicenter, all other banks throughout
the country will be adopting a new RRR of 17.5%, starting on Jun 25. Looking
ahead, it is likely that the RRR will increase further to 19% in 3Q08. Even so,
elevating the RRR without raising the cost of capital in tandem, does not seem
to be enough to bring down inflationary pressure in this cycle.
Real deposit rates have been falling with each increase in inflation. So have
lending rates in real terms. Yet, the authorities fear that raising interest rates
will encourage even more ‘hot capital’ inflows that will lead to more currency
appreciation pressures.
To control lending without raising the cost of capital, further administrative
tools would have to be introduced to augment past measures. New CNY lending
for the first four months has already amounted to CNY1.8trn, already hitting
around 50% of the CNY3.6trn target for 2008, the amount by which new loans
increased in 2007 (Chart 5). There was also a sharp increase in foreign currency
loans in 1Q08 (Chart 6) to take advantage of a strengthening CNY. Fixed-asset
investment did not really decelerate in any meaningful way, at least when compared
with 2007.
Although many argue that raising interest rates cannot tame inflation, a negative
real rate environment would certainly help sustain aggregate demand. If neither
exchange rates nor interest rates can solve the problem, the best solution is to
To control lending
without raising the
cost of capital,
further
administrative
tools would have to
be introduced
Chart 5: Financial institution: new yuan lending
CNY, bn
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
Chart 6: Financial institution foreign currency loans
% YoY
65
55
45
35
25
15
5
0
2000 2002 2004 2006 Apr08 ytd
-5
Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08
wait for food supplies to normalize without raising rates. This is a route that
will neither upset the state banks nor drag down domestic demand. The downside
of this is that no one can be certain that food and energy prices will come down
substantially in the next six months. If these prices remain at these high levels,
inflation expectations will be driven up even further, subsequently increasing
inflationary pressures.
Fed’s rate hike cycle in 4Q08- an opportunity for the PBOC to resume rate increases
The PBOC may well be waiting for the Fed to kick-off the rate hike cycle. Our
US economist expects the Fed funds target rate to increase by 50bps in 4Q08,
followed by a total of 75bps lift in 1Q09. This will be the best time for China to
play catch-up in hiking interest rates. If the annual inflation rate for 2008 indeed
exceeds 6%, compared with 1Y lending and deposit rates currently standing at
73

Economics: China
Economics – Markets – Strategy
7.47% and 4.14% respectively, it is not unreasonable to project that hikes on
domestic rates will resume. We now look for hikes (27bps each) in 4Q08, 1Q09
and 2Q09.
If the priority is to tame inflation, raising interest rates to slow domestic demand
should be a more effective measure, the proven route taken in 1992-94. However,
CNY appreciation must be slowed sufficiently to around 3%-4% in 2009 to reverse
the ‘expectation factor’.
While this may be unappealing to both policymakers and investors right now,
the risk is that by not changing the policy mix sooner rather than later, the
inevitable hike may need to be greater than if rates are increased now. Indeed,
weakening domestic demand may yet prove to be the ultimate solution to the
ongoing inflationary problems in China.
74

Economics – Markets – Strategy
Economics: China
China Economic Indicators
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real GDP growth 11.9 10.0 9.0 10.5 10.3 10.1 9.5 9.2 9.0
GDP by expenditure: current price
Private consumption 14.9 15.8 13.5 17.4 17.2 14.4 14.0 13.5 12.9
Government consumption 19.1 19.5 16.5 21.0 21.0 18.0 18.0 17.5 17.0
Fixed asset investmt growth (ytd) 25.8 23.0 20.0 25.9 23.0 23.0 20.0 18.0 17.5
Retail sales - consumer goods 16.8 18.4 16.3 20.6 17.5 18.0 17.5 16.0 15.5
External
Exports (USD bn) 1,218 1,474 1,769 306 359 398 410 401 423
- % YoY 26 21 20 22 22 20 21 18 18
Imports (USD bn) 956 1,203 1,516 265 287 325 326 327 356
- % YoY 21 26 26 28 26 26 24 24 24
Trade balance (USD bn) 262 269 252 41 71 73 84 74 67
Current account balance (USD bn) 372 450 520 n.a. n.a. n.a. n.a. n.a. n.a.
% of GDP 11 11 11 n.a. n.a. n.a. n.a. n.a. n.a.
Foreign reserves (USD bn, eop) 1,528 1,882 2,195 n.a. n.a. n.a. n.a. n.a. n.a.
FDI inflow (USD bn, YTD) 83 85.4 60 27.4 24 20 14 15 28
Inflation & money
CPI inflation 4.8 6.5 4.5 8.0 8.0 5.0 5.0 4.5 4.0
RPI inflation 3.8 5.8 3.5 7.4 7.0 4.8 4.0 3.5 3.0
M1 growth 21.0 17.7 17.0 18.3 18.0 17.5 17.0 17.0 16.5
M2 growth 16.7 15.8 15.0 16.3 16.2 15.8 15.0 15.0 14.5
Other
Nominal GDP (USD bn) 3,280 4,232 4828 n.a. n.a. n.a. n.a. n.a. n.a.
Fiscal balance (% of GDP) 1.5 2.0 2.2 n.a. n.a. n.a. n.a. n.a. n.a.
* % change, year-on-year, unless otherwise specified
CN – nominal exchange rate
CNY per USD
7.80
7.70
7.60
7.50
7.40
7.30
7.20
7.10
7.00
6.90
6/11/2007 10/10/2007 2/8/2008 6/10/2008
CN – policy rate
%, 1-yr lending rate
7.5
7.0
6.5
6.0
5.5
5.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC and DBS Research (forecasts and data transformations)
75

Economics: Hong Kong
Economics – Markets – Strategy
HK: Rates bottom, good for
inflation
• First quarter GDP data surprised on the upside at 7.1% YoY, maintaining
the pace in 4Q07. The external sector, a drag on growth last year, was more
resilient than expected despite a weak US
• Going forward, we continue to expect consumption to grow above trend,
but less than in 2007
• Our revised Fed forecasts imply that Hong Kong interest rates would be
heading up as soon as 4Q08. We would be looking at a nominal prime
lending rate of about 5.75%-6.00% in 4Q08 or real rate of about a mild
1.5%-1.7%
• This will be positive for Hong Kong in light of current high inflation
Domestic economy
remained strong...
...while the
external sector
was more resilient
than expected
1Q GDP surprised at 7.1% YoY
First quarter GDP data surprised on the upside at 7.1% YoY, maintaining the
pace in 4Q07 (6.9% YoY) (Chart 1). On a sequential basis, GDP growth rose 7.2%
(QoQ, saar). Domestic demand held up decently. Investment edged higher to
8.9% YoY, helped by the rebound in expenditure on building and construction
of the public sector, which jumped 16.3% YoY. Private consumption growth
registered a healthy 7.9% YoY, but is clearly cooling off from the peak in the
latter half of 2007.
The external sector, a drag on headline growth last year, was stronger than
expected despite the weak US. Goods exports rose 10.5% YoY in 1Q08 on the
back of sustained demand from Europe, Asia and other emerging economies
(Chart 2). In fact, year-to-date (Jan-Apr 2008) merchandise exports growth rose
11.5% YoY, stronger than the same period last year, leading us to adjust our
HONG KONG
Chart 1: Real GDP growth
%-pt contribution to GDP growth
12
10
8
6
4
2
0
-2
PCE
GCE
-4 Investment
Changes in Stocks
Net Exports
GDP, YoY
-6
4Q05 3Q06 2Q07 1Q08
Chart 2: Exports by country
%-pt contribution to export growth, YoY 3mma
China Europe ASEAN USA Others
13
11
9
7
5
3
1
-2
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08
Connie Tse • (852) 3668 5695 • connietsecy@dbs.com
76

Economics – Markets – Strategy
Economics: Hong Kong
full-year exports forecast slightly higher to 8%. These figures are in favor of our
view that there is an ongoing structural change in the world’s final demand,
that is, Asian demand is driving global growth nearly as much as the US and
may soon surpass it.
Softer, but still healthy, domestic-demand led growth
Going forward, we continue to expect domestic consumption to maintain abovetrend
growth, but as mentioned before, it is unlikely to be as spectacular as
2007. Investor sentiment was clearly dampened by the turmoil in global markets.
Money supply and loan growth retreated back from the peak in 4Q07 to slower,
but more sustainable levels (Chart 3). Meanwhile, the development of the labor
market was in-line with our earlier projections. In the first four months of this
year, unemployment (s.a.) stalled at around the 3.3%-3.4% levels (Chart 4), indicating
that the labor market has remained tight, but further improvement seems to be
rather limited this year. Employers are more cautious in hiring amidst the global
uncertainties. Accordingly, payroll growth might start to stagnate in the third
quarter and lag behind increases in inflation. But this will unlikely last in the
longer-term, assuming inflation will show signs of leveling off in 4Q08.
Chart 3: Money supply and loan growth
% YoY, 3mma % YoY, 3mma
30
25
20
15
10
5
0
M3 (LHS)
HKD Loans (LHS)
HSI (RHS)
-10
-20
-5
-30
Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08
70
60
50
40
30
20
10
0
Chart 4: Labor market
% YoY %
Employment (LHS)
7
2
Nominal Payroll (LHS)
6
Unemployment Rate (RHS)
3
5
4
4
3
2
1
0
7
-1
8
-2
Latest: Apr08
-3
9
Jun-01 Jul-02 Aug-03 Sep-04 Oct-05 Nov-06 Dec-07
5
6
Inflation to accelerate in 3Q08…
Consumer inflation has surprised
on the upside, mainly because
of higher import prices. Accordingly,
we have adjusted our 2008
consumer inflation forecast higher
to 5.0% YoY from 3.8% earlier.
As of April, CPI inflation edged
up to 5.4% YoY (Chart 5). Like
the rest of the world, Hong Kong
was not spared from the surge
in global oil nor food prices, and
the weak Hong Kong dollar made
imports even more expensive.
The prices of both Brent and WTI
crude oil have climbed above
USD130/bbl. Not only do car
Chart 5: CPI
%-pts contribution to CPI YoY
6.5
Food Non Food
5.5
4.5
3.5
2.5
1.5
0.5
Latest: Apr08
-0.5
May-06 Oct-06 Mar-07 Aug-07 Jan-08
CPI inflation has
surprised on the
upside owing to
higher import
prices
77

Economics: Hong Kong
Economics – Markets – Strategy
owners have to spend increasingly more on fuel, the persistently high energy
prices have also pressured public transport companies to call for fare hikes.
After giving the go-ahead for an increase in taxi fares, the government has
approved five of six bus fare rise applications, followed by increases in ferry
fares (effective July).
Meanwhile, food prices have continued to rise alongside that of China’s (Chart
6), accelerating at an 11% (YoY, 3mma) pace by April. The snowstorm disaster in
China earlier this year made it difficult for food prices to come down, and the
latest Sichuan earthquake is likely to prolong inflation expectations. Sichuan
has been known to be one of China’s significant agricultural areas, specifically
grain and pork. Under these circumstances, it may take a longer-than-expected
period, probably another quarter or two, for imported food prices from China
to normalize - absent further unforeseen and negative surprises.
But if we take a closer look at the breakdown, inflation does not seem to be
exclusively a food and fuel price story. Housing rentals, which explain nearly
one-third of inflation, have been rising steadily too (Chart 7). Negative real
mortgage rates have helped keep property prices afloat. Even with government’s
property tax (rates) waiver, housing inflation reached 5.5% YoY by Apr08.
Chart 6: Food prices
% YoY % YoY
25
20
15
10
5
0
CN: CPI: Food (LHS)
HK CPI: Food (RHS)
Latest: Apr08
-5
-4
Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08
12
10
8
6
4
2
0
-2
Chart 7: Residential property
1999=100
140
130
120
110
100
90
80
70
Property Price Index
Property Rental Index
60
Latest: Apr08
50
Jun-01 Sep-02 Dec-03 Mar-05 Jun-06 Sep-07
... before leveling off on higher interest rates and a stronger currency
As Hong Kong runs a currency peg with the USD, the government has to resort
to fiscal measures when it comes to tackling inflation. The fact that monetary
policies are indirectly tied to that of the US has been a concern to many in this
inflationary cycle, as easing in Fed funds rate would increase inflationary risks
in Hong Kong. In the past eight months, Hong Kong’s interest rate movements
and its inflation cycle have gone out of synch. Hong Kong’s prime lending rate
dropped by a total of 250bps alongside the Fed’s rate cut cycle, while CPI inflation
on the other hand, more than tripled (Chart 8).
But what if the latest developments in the US suggest that the Fed might take a
breather in June? Our US Economist’s view is that consumption will hold up and
the slowest growth in the US lies in the past, not up ahead. In fact, our Fed
forecast has been revised. We now look for 50bps of Fed hikes by year-end and
another 75bps of hikes in 1Q09. This implies that Hong Kong interest rates
78

Economics – Markets – Strategy
Economics: Hong Kong
would be heading up as soon
as 4Q08. Hence, Hong Kong’s
real prime lending rate would
return to the positive territory.
We are looking at a nominal
prime lending rate of 5.75%-
6.00% in 4Q08 or a mild real
rate of about 1.5%-1.7%.
Good news for the economy?
Probably not to those who
are still paying off their home
mortgages (most mortgages
are set with reference to the
prime rate), but on the inflation
front, this could be a positive
development as interest rate
movements would be more
in synch with the inflation
cycle (Chart 8).
Chart 8: Inflation vs prime lending rate
% YoY
10
5
0
-5
CPI (LHS)
Prime lending rate (RHS)
%, pa
13
out of
sync 12
-10
1Q90 1Q96 1Q02 1Q08
Assuming the US economy is out of the woods (no recession at least), and China
is able to engineer an orderly and gradual slowdown - which is our base case
scenario - there is less to worry about on the economic growth front. By then, in
light of inflation, higher interest rate levels would be seen as a catching up
process. The economy will likely to have withstood the projected interest rate
hikes assuming real GDP growth of at least 4% YoY.
Import prices in Hong Kong may soften following Fed’s rate hike cycle because
firstly, on reduced inflationary pressure from China, a major import destination.
When Fed rates go up, the People’s Bank of China (PBOC) will likely utilize this
opportunity to catch up with domestic interest rate rises, hence, taming inflation
(refer to China: Rethinking the strategy of CNY appreciation). Previously, the
Fed’s 225bps of rate cuts have made it ‘harder’ for the PBOC to deal with inflation
by raising local rates because of the widening rate gap between the USD and
CNY. Officials were concerned that rate hikes would aggravate speculative inflows
into China, further fanning inflation in the process.
Secondly, by then, the Hong
Chart 9: Real Effective Exchange Rate
Kong dollar will unlikely be
as weak as it was in the first Jan 2000=100
half of the year, which should
84
also help ease imported inflation.
Earlier this year, the weakness 82
of the USD, and hence HKD,
continued to fuel imported 80
inflation. In real effective
USD/HKD
78
exchange rate terms, the HKD
fell by some 4% in 1Q08, 76
compared to last year’s 5.6%
depreciation for the whole of 74
2007 (Chart 9). According to
72
research by the Hong Kong
Latest: Mar08
Monetary Authority, the 70
estimated contribution of Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07
exchange rate depreciation was
0.6 ppts in 2007, or about 20%
of the underlying inflation in that year.
As such, the potential bottoming of Fed rates in 2Q08 followed by Fed rate
hikes in 4Q08 may put a halt to a further weakening of the USD, and hence, the
11
10
9
8
7
6
5
4
Higher interest
rates should help
lower inflation
Import prices to
soften
79

Economics: Hong Kong
Economics – Markets – Strategy
HKD. We expect the HKD to move with the USD’s rebound against both EUR &
JPY (refer to Currencies).
Of course, this outlook is not without risks. At the end of the day, the degree of
inflationary pressures can be alleviated will hinge greatly on the trend of global
prices. There is only so much the exchange rate can do, especially if global oil/
commodities prices continue to soar at this pace.
80

Economics – Markets – Strategy
Economics: Hong Kong
Hong Kong Economic Indicators
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
GDP growth (06P) 6.4 5.2 4.7 7.1 4.8 4.8 4.3 4.7 5.8
Private consumption 7.8 5.8 4.6 7.9 6.2 5.4 3.8 5.5 3.7
Government consumption 2.3 2.4 2.5 0.3 1.8 3.6 4.1 3.8 3.7
Gross fixed capital formation 4.2 5.7 4.7 8.9 2.3 4.6 7.3 6.3 8.6
Net exports (HKD bn) 160 170 181 41 25 58 46 39 28
External (nominal)
Merch exports (USD bn) 345 372 402 83 91 99 100 89 97
- % YoY 9 8 8 10 8 7 7 7 7
Merch imports (USD bn) 368 402 436 90 100 105 109 97 108
- % YoY 10 9 8 12 9 8 8 8 8
Trade balance (USD bn) -23 -29 -34 -7 -9 -6 -9 -8 -11
Current acct balance (USD bn) 28 25 28 - - - - - -
% of GDP 13.5 11.0 11.3 - - - - - -
Foreign reserves (USD bn, eop) 153 165 175 - - - - - -
Inflation
CPI inflation 2.0 5.0 4.0 4.6 5.6 5.4 4.3 4.2 4.1
Other
Nominal GDP (USD bn) 207 228 248 - - - - -
Unemployment rate (%, sa, eop) 4.4 3.4 3.4 3.4 3.4 3.5 3.4 3.4 3.4
* % change, year-on-year, unless otherwise specified
^ Balance on goods and services
HK – nominal exchange rate
HKD per USD
7.84
HK – policy rate
%, base rate
8.0
7.82
7.80
6.0
7.78
7.76
4.0
7.74
6/11/2007 10/10/2007 2/8/2008 6/10/2008
2.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC and DBS Research (forecasts and data transformations)
81

Economics: Taiwan
Economics – Markets – Strategy
TW: Staying on track
• We have lifted the 2008 inflation forecast to 3.4% from 2.2%, reflecting
the surge in crude oil prices and the new government’s deregulation of
domestic oil prices
• We maintain our 2008 GDP forecast at an above-consensus 5.0%. Although
inflation would hurt consumption, investment recovery is expected to
be sustained on the back of improving investor sentiment, warmer crossstrait
economic ties and the new government’s promotion of infrastructure
construction
• With inflation risks outweighing growth risks, we project the central
bank to extend its rate hike cycle to the year-end. Hikes of 12.5bps per
quarter are expected at each of the next three MPC meetings in June,
September and December
TAIWAN
Strong exports and
defensive financial
markets are in line
with expectation
1H08 Recap
The economy moved smoothly through the first half of the year in spite of US
weakness and global financial market turmoil. In line with our expectations,
exports managed double-digit growth during Jan-May (averaged 17.5% YoY),
helped by still-robust demand from China and other emerging markets. Meanwhile,
despite generally weakening capital flows since the US subprime crisis, Taiwan
experienced rising foreign capital inflows and the repatriation of domestic capital
outflows in 1H08. Investor optimism has been reinforced following the opposition
KMT party’s winning of the presidential election in March, which laid the ground
for a stable political climate, closer cross-straits ties and therefore brighter economic
outlook. Foreign exchange reserves jumped as much as USD 19.8bn in Jan-May,
in sharp contrast with the USD 4.2bn increase recorded during the whole year of
2007. The Taiwan dollar appreciated an impressive 6% year-to-date, and the
TAIEX also well outperformed the regional stock markets.
The GDP report showed that
the economy expanded by
a decent and balanced 6.1%
YoY in 1Q08 (Chart 1). Net
exports and domestic demand
contributed almost equally
to the overall growth (2.9ppt
and 3.2ppt respectively).
Exports of goods and services
rose a steady 11.4%, not very
different from 11%-13%
registered in 3Q-4Q07. Private
consumption also remained
stable at 2.0%, close to its
trend rate over the past eight
quarters. Fixed investment
showed notable resilience,
bouncing back to 5.8% from
the temporary setback in 4Q07.
Chart 1: Solid growth
% YoY
12
8
4
0
-4
-8
PCE
GFCF
GDP
GCE
Net Exports
1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08
Ma Tie Ying • (65) 6878 2408 • matieying@dbs.com
82

Economics – Markets – Strategy
Economics: Taiwan
Inflation becomes a near-term risk
The unexpected development in the first half mainly
is higher inflation. Headline and core CPI inflation
both remained sticky so far this year, around 3.8%
YoY and 3.1% respectively (Chart 2). Although import
prices have eased somewhat thanks to the appreciation
in the Taiwan dollar, the upside risks have risen
again due to the further surge in global crude oil
prices. Moreover, the new government has removed
the temporary controls on domestic oil prices imposed
by the former administration over the past six months.
A hike ranging from 12-16% on gasoline and diesel
fuel prices was announced on May 27, while the
future domestic oil prices will be adjusted monthly
based on the international prices benchmark. Also,
a 21% hike on electricity prices has been scheduled
to follow suit in July. Considering that oil and electricity
account for 3.3% and 2.2% respectively of the CPI
basket, and the hikes would spill over onto other
oil-linked prices such as transportation costs, we
have lifted 2008 inflation forecast to 3.4% from
2.2% projected one quarter ago.
Chart 2: Sticky inflation
% YoY
6
5
CPI Core CPI
4
3
2
1
0
-1
-2
-3
May-00 May-02 May-04 May-06 May-08
The cost-push inflation is expected to develop into a near-term threat to the
nascent recovery in domestic demand. We think the adverse impact would largely
fall on consumers especially wage-earners as purchasing power is squeezed. The
rise in inflation has dragged real income growth into the negative territory ever
since 4Q07, and should continue doing so in the remainder of this year (Chart
3). Largely ascribed to the deterioration in inflation expectations, consumer
confidence has weakened again in May following a temporary rebound during
the election period (Chart 4). We think the elevated inflationary pressure would
offset the positive factors such as better post-election economic climate and the
dissipating fallout of credit and cash card crisis, which would hence delay the
recovery in private consumption to 2009 (rather than 2H08 as we previously
expected).
Higher-thanexpected
inflation
would delay
consumption
recovery
Chart 3: Real income growth falling to negative
% YoY, 3mma
5
4
3
2
1
0
-1
Average Monthly Regular
Earnings (inflation adjusted)
Chart 4: Consumer confidence hurt by inflation
120
100
80
60
40
-2
-3
20
Consumer confidence
Level of Commodity Prices
-4
Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08
0
May-02 May-04 May-06 May-08
83

Economics: Taiwan
Economics – Markets – Strategy
Investment
recovery is likely to
sustain
The negotiations
with China on
tourism and
transportation
issues are
progressed
smoothly
Still, growth drivers on the way
Despite the downside risks caused by inflation, we maintain our 2008 GDP forecast
unchanged at 5.0%, as we think the new government’s policy stimulus will
bode well for a sustained investment recovery in 2H08.
The blueprint planned by the new government centers on strengthening economic
ties with China and promoting infrastructure investment in the island. The new
president Ma Ying-jeou has pledged to establish weekend direct charter flights
and allow the direct entry of tourists from China starting from July. As we pointed
out previously, these two are relatively mature proposals reflecting improving
cross-strait economic relations, as the negotiations on related technical details
have already moved forward over the last two years. Since the ending of presidential
elections in March, interactions between Taiwan’s new leaders and China’s top
government officials have been warm. The bilateral dialogue between the semiofficial
Straits Exchange Foundation (Taiwan) and the Association for Relations
across the Taiwan Strait (China), which has been suspended for almost a decade,
is now scheduled to resume on June 11-14. The weekend charter flights and
tourism issues will be the focus of this meeting, and a formal official agreement
is likely to be formulated successfully according to newswire reports. We stay
optimistic in this regard. Tourism revenue alone (brought by 3000 China tourists
per day) is estimated to add annual GDP growth by 0.4ppt (Chart 5). The positive
effect on investment, employment and income growth in related industries
would be even more significant.
Chart 5: Tourism revenue to grow
%
2.0
1.5
1.0
0.5
Visitors Arrivals (RHS)
Tourism revenue/GDP
mn,
persons
6
5
4
3
2
1
Chart 6: Saving-investment gap widening
%
31
29
27
25
23
21
19
17
Saving / GDP
Investment / GDP
0.0
1991 1994 1997 2000 2003 2006 2009F
0
15
1997 1999 2001 2003 2005 2007
Infrastructure
investment could
be funded through
the private sector
The new president also promised to promote the “I-Taiwan 12 infrastructure
projects” over the next eight years, which amount to a total of TWD 4trn (3% of
GDP per year). We concur that investment is a much-needed driver for Taiwan’s
economy. The external-internal imbalance has widened for years - trade surplus
stayed persistently strong, but investment has been massively relocated overseas
due to sluggish confidence on domestic politics and the long-term trend of
globalization. As a result, the saving-to-investment gap has widened sharply,
from 2.8% (of GDP) in 2000 to 9.5% in 2007 (Chart 6). It is true that the infrastructure
investment plan targeted by the government appears somewhat ambitious in
light of its still-weak fiscal position (-0.2% of GDP in 2007) and rising fiscal
burden resulting from fuel subsidies this year. Nevertheless, we think the official
proposal of raising 1/3 funds from the private sector (via the BOT model) is
feasible. Moreover, the leading role played by the government in increasing
84

Economics – Markets – Strategy
Economics: Taiwan
investment should be valued, in terms of helping restore investor confidence in
the island.
Taking into account the above positive factors, we expect the revival in investment
especially private investment to sustain into 2H08 and 2009. Combined with the
downside risks on private consumption, the overall GDP growth is likely to slow
moderately towards 4% in 2Q-3Q08 and then bounce back to 5% from 4Q08.
Monetary policy: the CBC takes a long-term perspective
Taiwan’s central bank (CBC) maintained monetary tightening over the past three
quarters, in contrast to the aggressive Fed rate cuts and the wait-and-see approach
adopted by most Asian central banks. We think the CBC is taking a long-term
perspective. At the 1Q monetary policy committee meeting in March, the CBC
remained comfortable with growth outlook this year, saying that the 4.3% growth
projected by the government think-tank National Statistics is “close to the 10-
year growth average”. By contrast, the CBC cited inflationary pressures as the
key reason for rate hikes, which is no surprise given that the current inflation
rates of 3-4% are far above the 10-year average of less than 1%.
Compared to one quarter ago, the National Statistics has upgraded their 2008
growth forecast to 4.8% from 4.3% after the release of 1Q GDP report, and
lifted inflation forecast to 3.3% from 2.0%. Clearly, this means the official view
is that inflation risks have further risen and growth risks are lower than they
previously feared. Consequently, chances are high that the CBC will place inflation
as the top policy concern and extend the rate hike cycle. Apart from the 12.5bps
rate hike projected for June, we have added two more 12.5bps hikes into our
policy forecast for 2H08, which will lift the benchmark rediscount rate to 3.875%
by the year-end.
The short-term money market rates, deposit rates and new loan rates are currently
below inflation and also policy rate, at merely 2-3% (Chart 7). Even after further
hikes of 37.5bps, real rates would only get closer to the zero level. Moreover,
capital inflows is unlikely to fade substantially going forward. Taiwan should
remain attractive to foreign investors and domestic investors staying offshore
as they bet on increasing integration with the mainland over the medium term.
Consequently, market interest rates should continue to edge upward at a more
gradual and moderate pace than policy rate in the coming quarters. In sum,
liquidity conditions should remain supportive to economic growth, despite the
possibility of more rate hikes.
The official
forecasts of
inflation and GDP
growth have both
been lifted
Expect more rate
hikes ahead, but
liquidity conditions
should remain
supportive to
economic growth
Chart 7: Real rates still negative
% YoY, % pa
10
8
6
4
2
0
-2
CPI
Rediscount Rate
New Loans Rate
Deposit Rate: 1 Yr
May-98 May-00 May-02 May-04 May-06 May-08
Chart 8: External position strengthening
USD bn
15
10
5
0
-5
-10
-15
Current Account
Financial Account
Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08
85

Economics: Taiwan
Economics – Markets – Strategy
Taiwan Economic Indicators
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
GDP growth 5.7 5.0 5.4 6.1 4.0 4.5 5.3 4.8 5.5
Private consumption 2.6 2.2 3.2 2.0 2.0 1.7 3.0 3.0 3.2
Government consumption 0.8 1.9 2.0 1.7 1.8 2.0 2.2 2.0 2.0
Gross fixed capital formation 2.4 5.8 6.1 5.8 3.0 5.1 9.2 5.2 7.4
Net exports (TWDbn, 01P) 2040 2357 2677 561 545 540 712 625 614
Exports (% YoY) 8.8 8.6 8.7 11.4 10.2 7.2 6.0 6.5 7.5
Imports (% YoY) 3.7 6.5 7.1 9.0 8.0 5.0 4.4 4.9 6.0
External (nominal)
Merch exports (USDbn) 247 282 321 64 70 72 75 72 78
- % chg 10.1 14.1 14.0 17.6 17.3 12.0 10.7 11.8 12.0
Merch imports (USDbn) 219 257 292 61 65 66 65 67 72
- % chg 8.2 17.2 13.6 26.0 17.4 14.5 12.4 10.1 11.7
Trade balance (USD bn) 27 30 36 3 5 6 10 5 6
Current account balance (USD bn) 32 31 37 - - - - - -
% of GDP 8.3 7.2 8.3 - - - - - -
Foreign reserves (USD bn, eop) 270 301 319 - - - - - -
Inflation
CPI inflation 1.8 3.4 2.4 3.6 3.9 3.9 2.1 3.4 2.6
Other
Nominal GDP (USDbn) 383 428 445 - - - - - -
Unemployment rate (%, sa) 3.9 3.9 3.8 3.9 3.9 3.9 3.9 3.8 3.8
* % growth, year-on-year, unless otherwise specified
TW – nominal exchange rate
TWD per USD
33.5
33.0
32.5
32.0
31.5
31.0
30.5
30.0
29.5
6/10/2007 9/9/2007 12/9/2007 3/9/2008 6/8/2008
TW – policy rate
%, rediscount rate
5.0
4.0
3.0
2.0
1.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
86

Economics – Markets – Strategy
Economics: Taiwan
This page is intentionally left blank
87

Economics: Korea
Economics – Markets – Strategy
KR: Surviving
• Despite strong exports, domestic demand growth has fallen due to higher
energy prices, financial market volatility and political troubles
• But there is room for both fiscal and monetary stimulus to help the economy
survive the current difficulties
• We have lowered our 2008 GDP forecast to 4.6% from 4.8% last quarter,
but maintain our 2009 forecast at 5.0% for now
1Q08 Recap
GDP growth slowed to a sub-par 3.3% (QoQ saar) in 1Q08, significantly down
from the robust 6%-7% rates of the previous three quarters (Chart 1). Exports
preformed well in line with our expectations, but domestic demand deteriorated
unexpectedly. Private consumption growth fell to 1.8%, the slowest pace since
the 2004 credit card crisis. Fixed investment declined 3.4% QoQ saar, marking
the sharpest contraction over 13 quarters.
Chart 1: Growth slowed on domestic demand
% QoQ saar
18
14
10
6
2
-2
-6
GDP PCE GFCF
-10
1Q03 4Q03 3Q04 2Q05 1Q06 4Q06 3Q07
Chart 2: Labour market deteriorating
%YoY,sa
2.5
2
1.5
1
0.5
0
%, sa
Employment
4.5
Unemployment Rate (RHS)
May-04 May-05 May-06 May-07 May-08
4
3.5
3
2.5
The labor market also lost steam. Employment growth dropped to below trend
levels earlier this year while the jobless rate has started to rise since March
(Chart 2).
KOREA
Still exposed to external risks
The markets (including us) have been focusing on assessing the impact of exports
slowdown on Korean economy as a result of US subprime crisis. There are two
other external risks - oil prices and financial market volatility – which have been
underestimated previously. Global crude oil prices continuously broke record
over the past few months and now stand at all-time highs of USD130/barrel. The
adverse effects from oil prices on economic growth emerged fast in Korea, as it
Ma Tie Ying • (65) 6878 2408 • matieying@dbs.com
88

Economics – Markets – Strategy
Economics: Korea
is one of the few countries in the region adopting floating oil pricing mechanism,
while the oil-intensive industry is also important for Korea compared to its
counterparts such as Hong Kong and Singapore. High oil prices squeeze consumer
purchasing power and corporate profit margins. From a macro perspective, the
surge in oil prices has resulted in the worsening of terms-of-trade.
Meanwhile, concerns over external debt have also triggered some volatility in
financial markets amid global financial turmoil. Short-term external debt has
risen since 2006 and reached 16% of GDP in 2007, double the steady 8% pace
seen in 2000-2005 (Chart 3). Importantly, foreign reserves remain sufficient to
cover such a debt level, substantially different from the situation ahead of Asian
financial crisis. More importantly, a large portion of today’s external debt is
caused by the banks’ hedging of long-USD positions following the exporters’
USD forward selling, which is also different from decade ago when companies
heavily borrowed from overseas to fund domestic investment expansion. We
do not think the problem of external debt is alarming, but markets are pricing
in higher risk premium. Short-term money market rates have risen, boosting
bank lending rates by an additional 20bps since the last BOK rate hike in Aug07
(Chart 4). The Korean won depreciated sharply since March and accumulated a
loss of 10% (against USD) by beginning-June. Higher borrowing costs and weaker
currency should both have played a role in weighing down domestic demand.
Oil prices hit
domestic demand
quickly
External debt is not
high but triggered
financial volatility
Chart 3: External debt rising
%
20
15
10
5
Short-term External Debt / GDP
Short-term External Debt /
Foreign Reserve (RHS)
%
350
300
250
200
150
100
50
Chart 4: Lending rates elevated
%
10
8
6
4
2
Policy Rate
Lending Rate: New Loans
CD Rate: 3m
0
1995 1997 1999 2001 2003 2005 2007
0
0
May-00 May-02 May-04 May-06 May-08
And, some internal noises
Since the government agreed in April to lift bans on imports of US beef, there
has been widespread criticism due to public worries over the beef safety. Opponents
have held large-scale street protests demanding that the US deal be scrapped or
renegotiated.
Combined with the oil prices pain and financial volatility, public sentiment has
been hit further. Consumer confidence which started to weaken since March
dropped sharply in May, touching its lowest level ever since 2004 (Chart 5).
The intensifying protests finally triggered political storm. The Prime Minister
and the entire Cabinet offered their resignations on June 10, holding themselves
responsible for the dispute. It is reported that the president will accept the
resignations selectively and a cabinet reshuffle is likely to occur soon next week.
The beef deal
caused protests and
a cabinet reshuffle,
further hitting
public sentiment
89

Economics: Korea
Economics – Markets – Strategy
A solid fiscal
position provides
scope for increasing
expenditure and
lowering taxes
Policy rates have
returned to 2000
levels; real rates are
positive
Fiscal stimulus to counter slowdown
In face of these difficulties,
the Ministry of Strategy and
sa
Finance (MOSF) has taken
110
a string of fiscal stimulus
measures in recent months.
These include tax rebates and
100
subsidies to relieve the impact
of high oil prices on lowincome
consumers and selfowned
businesses (KRW10.5 90
trn, 1.2% of GDP), and budget
reallocation to help growth
and job creation (KRW2.5trn, 80
0.3% of GDP). Also, it is
reported that the government
is seeking a supplementary 70
budget and planning to bring
forward corporate tax cuts
into this year (5ppt over the
next five years as previously scheduled).
Indeed, Korea has registered consecutive years of fiscal surplus since 2000, and
last year’s surplus has reached a record high of 3.8% of GDP. Solid fiscal position
should have provided scope for the government to increase spending and lower
tax burden this year. We think the general direction of expansionary fiscal policy
is justified and could be maintained ahead, despite some uncertainties on the
implementation timeliness caused by the upcoming cabinet reshuffle.
Monetary stimulus: room also remains
The Bank of Korea (BOK) has kept the policy rate unchanged at 5.0% so far this
year, balancing concerns of slower growth with higher inflation. Minutes of the
April MPC meeting showed that 2 of 6 members voted for a 25bps rate cut,
saying that “a preemptive rate cut could keep the economy from slowing given
inflation is expected to moderate ahead”. Thoughts of rate cuts have been deterred
by the continued acceleration in inflation, which broke 4% since April. In the
absence of a sign showing inflation is peaking, the BOK would have to cautiously
stay on hold for a few more
months, in order to avoid
intensifying public inflation
expectations.
Nevertheless, we think room
remains for the BOK to ease
monetary policy and support
economic growth, if
necessary. The BOK’s rate
hike campaign over the past
three years has already taken
policy rates back to normal.
With deposit and lending
rates now at 5.5%-7.0%,
Korea’s rates remain positive
in real terms, in contrast
with the negative real rates
seen in most Asian economies.
Indeed, the BOK has been
Chart 6: The BOK moving ahead of the curve
% pa, % YoY
10
Chart 5: Sentiment weakening
8
6
4
2
Consumer Expectation
BSI
May-03 May-04 May-05 May-06 May-07 May-08
Policy Rate
CPI
Lending Rate: Newly Extended
Deposit Rate: Newly Extended
0
May-00 May-02 May-04 May-06 May-08
90

Economics – Markets – Strategy
Economics: Korea
moving ahead of the curve (Chart 6). Last year for instance, they hiked rates as
early as 3Q07 when growth had risen above potential for merely one quarter,
and inflation stayed fairly stable at the lower-end of policy target (2.5-3.5%).
Thanks to the well-controlled consumer prices last year (2.5%), the inflation
average from Jan07 to May08 is 3.0%, only at the middle point of the policy
target (which is set for inflation average in 2007-2009). Indeed, a forward-looking
central bank should understand that cost-push inflation will unlikely sustain
very long as growth will also be dragged. The BOK is likely to make rate decision
based on growth trend, more than the lagging inflation data.
The BOK is likely to
focus more on
growth than on
inflation
Meanwhile, recent years of strong capital inflows, currency intervention and
monetary sterilization have left the BOK with large amount of foreign reserves
(27% of GDP, vs. 6% in 1996) and monetary stabilization bonds (17% of GDP, vs.
4% in 1996) (Chart 7). It appears that the BOK has injected liquidity into financial
system ever since 4Q07 to tame the rises in market interest rates, as evidenced
by the gradual declines in the amount of outstanding MSBs (Chart 8). Also, the
Chart 7: The BOK has the capacity of intervention
%
35
Foreign Reserve / GDP
30
MSBs / GDP
25
20
15
Chart 8: The BOK discharging liquidity
won trn
200
150
100
10
5
50
Outstanding MSBs
0
1991 1993 1995 1997 1999 2001 2003 2005 2007
0
Apr-98 Apr-00 Apr-02 Apr-04 Apr-06 Apr-08
BOK has the capacity to intervene the FX market and prevent the won from
excessive depreciation, if required. In fact, the won’s sharp drop in March-May
was partly fuelled by the government’s earlier enthusiasm of using a weaker
won to stimulate exports. Since the BOK heavily intervened in late-May and
the government reduced the talks on the benefits of a weaker won, the won/
dollar rate has stabilized.
Overall, we think Korea still has sufficient fiscal and monetary instruments to
help it survive the current difficulties. Growth is likely to remain low this quarter
and the next given the prevailing external and internal headwinds. The timing
of a recovery would largely hinge on the implementation of fiscal stimulus,
and BOK policies. We downgraded 2008 GDP growth forecast to 4.6% from
4.8%, but maintain 2009 forecast at an above-potential 5.0% for now.
The timing of
growth recovery
hinges on the
implementation of
fiscal stimulus
91

Economics: Korea
Economics – Markets – Strategy
Korea Economic Indicators
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
GDP (00P) 5.0 4.6 5.0 5.7 4.8 4.3 3.8 4.3 4.8
Private consumption 4.5 2.7 3.2 3.4 2.9 2.2 2.2 2.5 3.0
Government consumption 5.8 2.7 3.1 4.0 2.6 2.9 1.5 2.5 2.8
Gross fixed capital formation 4.0 1.1 3.9 0.3 0.4 1.9 1.8 3.5 4.2
Net exports (KRW trn) 87 108 124 25 26 30 28 30 30
Exports 12.1 13.5 12.6 11.7 16.2 16.3 10.0 14.6 10.3
Imports 11.9 11.1 12.1 9.2 13.8 13.9 7.8 13.0 8.9
External (nominal)
Merch exports (USD bn) 371 448 524 99 116 113 119 118 133
- % YoY 14.1 20.7 16.8 17.4 24.8 25.3 15.7 18.2 14.8
Merch imports (USD bn) 357 443 510 105 113 109 116 117 127
- % YoY 15.3 24.2 15.0 28.2 28.1 26.4 15.7 10.7 12.3
Trade balance (USD bn) 15 5 14 -6 3 5 3 1 7
Current account balance (USD bn) 6 -3 5 - - - - - -
% of GDP 0.6 -0.3 0.5 - - - - - -
Foreign reserves (USD bn, eop) 262 265 276 - - - - - -
Inflation
CPI inflation 2.5 4.6 3.0 3.8 4.8 5.5 4.3 3.3 2.4
Other
Nominal GDP (USD bn) 970 942 959 - - - - - -
Unemployment rate (%, sa) 3.2 3.2 3.1 3.0 3.2 3.2 3.2 3.1 3.1
* % change, year-on-year, unless otherwise specified
KR – nominal exchange
KRW per USD
1,060
1,040
1,020
1,000
980
960
940
920
900
6/11/2007 10/10/2007 2/8/2008 6/10/2008
KR – policy rate
%, target rate
5.5
5.0
4.5
4.0
3.5
3.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
92

Economics – Markets – Strategy
Economics: Korea
This page is intentionally left blank
93

Economics: India
Economics – Markets – Strategy
IN: Rising growth, inflation
• We forecast above-consensus GDP growth of 8.6% in FY08 and expect
another 25bps increase in rates by Sep08
• Core inflation could remain above the RBI’s comfort level for the next 12
months. It would be a mistake to brush aside inflation readings as “supply
side” or “not domestically led” or merely “basis effects”. The oil price rise is
symptomatic of India’s (and emerging markets’) strong demand
• Consumption, credit and inflation slowed in Jun07-Sep07 due to the sudden
increase in interest rates in the first half of 2007. All three have recovered
sharply since then. The market focus on (declining) year-on-year growth
hides this pattern
• Overall, as long as fuel subsidy shields consumers from higher prices,
stability risks outweigh growth risks as fiscal and current account balances
widen sharply. Another risk is that, due to the central role played by the
software sector in job creation, India may be more dependent on the US
than trade-to-GDP ratios suggest
We expect aboveconsensus
GDP
growth of 8.6% in
FY2008 and
another 25bp
increase in rates
1Q08 GDP review and summary outlook
1Q08 GDP grew by 8.8% (YoY) Chart 1: GDP contributions - select components
much higher than consensus forecast
% YoY
of 8.1%. This meant that fiscal 14
2007 (ends Mar08) growth reached
9%. The break down of the 1Q08 12
GDP shows that consumption 10
spending held up (8.3%) while
investment spending faltered 8
(10.7%). We think the latter is a
logical business response to worries
about US recession. We think these
concerns should decline going
6
4
2
forward. Also, the economic outlook
0
would be more worrisome if the
Dec-05 Dec-06 Dec-07
GDP break down revealed that
consumption had slowed and
investment had held up. This is
because ultimately investment
Consumption
Government
Investment
GDP
outlook depends on consumption outlook. On this count, the 1Q08 GDP was
positive (Chart 1). As such, we continue to expect domestic demand to support
economic growth of 8.6% in FY2008 despite higher prices and rates.
INDIA
Domestic demand supportive but indirect US links via job market a risk
We believe the labour market remains supportive of growth in consumption
spending. Indeed, this is why consumption has stayed remarkably resilient in
the last three quarters despite sudden rates hikes in the first half of 2007 (Chart
2). However, in India, consumer and even business sentiment are quite tied to
the US-dependent software sector. The outlook is, therefore, not without uncertainties.
Ramya Suryanarayanan • (65) 6878 5282 • ramya@dbs.com
94

Economics – Markets – Strategy
Economics: India
Chart 2: Consumption spending accelerates
Levels, s/a, INR bn, 2qma
5,000
4,500
4,000
3,500
3,000
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08
On the surface, India’s net exports to GDP (including services such as software) is
only 18% of GDP. This is very low compared to the very open East Asian economies
where export shares are typically thrice as large. However, the software sector
has been key to India’s growth story especially with respect to job creation and
through that on consumption. Unfortunately, this sector is very dependent on
the US with almost 60% of exports headed to the US. Also, there are no hard
data available on the labour market to accurately assess the relative importance
of this sector for job creation.
Anecdotal evidence
suggests the labour
market remains
healthy
For now, anecdotal evidence and surveys by human resource companies suggests
the labour market remains healthy even as sentiment is hurt by worries over
possibility of a US recession. In fact, most major software companies cite the
rupee (in the past) and rising domestic wages as a bigger concern than the
exposure to US. Also, at the margin, software export growth is coming from
non-US destinations as corporates have been trying to diversify away from the
US. As such, most signs suggest consumption would hold up as long as US growth
doesn’t fall off the cliff.
As consumption demand continues to hold up, we expect a recovery in investment
spending too from the weaker 1Q08 (Chart 3). We think there is enough scope
for investment spending growth of 15% in India. Manufacturing PMI surveys
also point to a very strong manufacturing sector (Chart 4, next page)
Chart 3: Investment spending falters
Levels, s/a, INR bn, 2qma
3,000
2,500
2,000
1,500
1,000
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08
95

Economics: India
Economics – Markets – Strategy
Chart 4: Mfg PMI points to decent growth in industrial production ahead
% QoQ, saar, 2qma
25
IPI
PMI: Output
index, sa; 50= no chg
70
20
15
65
10
60
5
0
Latest: Mar08 (IPI), Apr08 (PMI)
-5
Jan-06 Jan-07 Jan-08
55
50
The economy
slowed in Jun07-
Sep07 and has
recovered nicely
since then (see
Charts 5 - 9 )
Year-on-year numbers to rise rapidly ahead, as month-on-month already has
There is a concern that growth has begun to slow in the last six months due to
declining year-on-year industrial production growth numbers. Such concerns
have been delaying rate hikes to control inflation. However, growth has not
begun to slow now, it slowed in Jun07-Sep07 and has rebounded in the last six
months. To a great extent, focus on year-on-year numbers have distorted the
interpretations of India’s economic data recently. To understand this, we go
back to what happened in 2007 and how that has affected growth patterns.
The RBI’s postponement of much needed rate hikes in 2006 (quarter-on-quarter
inflation was rising rapidly then following fuel price hikes) merely led to even
higher year-on-year inflation in first quarter of 2007 and application of sudden
brakes by the RBI in the first half 2007. Interest rates had to go up suddenly and
sharply as the increase came later than it should have. This sudden 200-400bp
increase in borrowing costs led to a temporary soft patch in consumption demand
that extended from Jun07-Sep07. Consumer demand and credit have rebounded
sharply since then broadly in line with our expectations.
We expected consumption to recover as we believed that rates were not at a
restrictive level per se but that the speed of the increase in rates simply had to
temporarily hurt demand. Hence, our expectation was for growth to recover
Chart 5: Mfg goods production
Levels, SA, 3mma
300
290
280
270
260
250
240
230
Interest rate
"shock" phase
Latest: Mar08
Jan-06 Jan-07 Jan-08
Chart 6: Consumer goods production
Levels, SA, 3mma
320
300
280
260
240
Interest rate
"shock" phase
Latest: Mar08
Jan-06 Jan-07 Jan-08
96

Economics – Markets – Strategy
Economics: India
Chart 7: Credit growth - heading towards 25%
% YoY, 3mma & % MoM, saar (6mma)
30
25
20
Chart 8: Broad money
% YoY, 3mma
25
20
RBI intervention kept money
growth high even in the
interest rate "shock" phase
15
10
5
RBI comfort level (~20%)
Credit % m/m saar
(6mma)
Credit % YoY (3mma)
Interest
rate
"shock"
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08
15
10
RBI comfort level
(~17%)
M3 % YoY (3mma)
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08
from this interest rate “shock” in the latter half of 2007 and it has. This recovery
is evident in the month-on-month growth trends not only in the industrial output
data (Charts 5 & 6) but also in the credit data (Chart 7). In fact, credit growth is
heading towards 25% growth rate again. Money growth at 22% (YoY) is also
much higher than RBI comfort level of 17% (Chart 8) though there was no
period of material moderation in money growth. This is because large capital
flows and RBI intervention kept money growth strong in the interest rate “shock”
phase also. This is why we believe worries about growth slowdown at a macro
level are presently misplaced.
Inflation to continue to rise
With growth rebounding nicely from the interest rate
“shock” and worries about a US recession expected to
ease, inflation risks are mounting. WPI has already breached
8% (YoY) as on week-ended May17. In fact, inflation
may already be in double digits as suggested by large
revisions to back dated data (week-ended Mar15 WPI
was revised up by 200bps). In any case, WPI is underestimated
due to oil subsidies. As such, we think manufacturing
WPI, a measure of core inflation, risks staying above
5% RBI comfort level in the next 12 months (Chart 9).
Chart 9: WPI Manufacturing
% YoY
Inflation: two pitfalls to avoid
4
(1) Inflation is *not* simply due to basis effects that
2
will “disappear” in a few months:
In fact, similar to the trend in consumer durable goods 0
output and credit numbers, inflation also has been rising
sharply in sequential terms after the “halt” in price
growth in the interest rate “shock” phase (Chart 9).
Therefore, inflation should not be brushed aside as a base effect phenomenon.
Certainly, basis effects exaggerate the inflation reading and we can expect a
decline in inflation in year-on-year terms especially if food price inflation moderates.
(2) Inflation is not simply led by “global” factors:
The fact that global commodity prices are driving up inflation should not be
taken to mean that inflation is due to “global” factors (as opposed to “domestic”
factors). In an integrated global market, domestic demand pressures of emerging
markets like that of China and India can together drive commodity price inflation
even though a single country’s demand may be too small to alter global prices.
12
10
8
6
RBI
comfort
% YoY
WPI manufacturing price level (RHS)
Interest rate
"shock" phase
Jan-06 Jan-07 Jan-08 Jan-09
Levels, s/a
210
190
170
97

Economics: India
Economics – Markets – Strategy
Even if India
produced all its oil
and operated as a
closed economy,
domestic oil prices
might have risen
due to oil demand
We expect another
25bp rate hike by
Sep08
So again the question to ask is who and what is ultimately responsible for the
rising global commodity price inflation? According to our analysis, (see section
“On a clear day”), in 2006, India and China together accounted for two-thirds of
the incremental petroleum demand and India alone accounted for about 15%
of the incremental demand. In other words, even if India produced all its oil
and operated as a closed economy, oil prices would have likely risen and fuelled
inflation. Fuel subsidies are also shielding India’s demand from higher oil prices,
so strong demand from India clearly plays a role in driving oil prices higher. It is
for this reason that we think that India should not ignore fuel price led inflation.
It is imperative in the long-run to cut subsidies, let the price mechanism work
and avoid “suppressed” inflation.
Interest rate: not yet peaked from a longer-run perspective
It is clear that the rising headline inflation rates should not be ignored. Rising
inflation pushes down real interest rates and increases wage hike demands creating
a risk of wage-price spiral. Indeed, the RBI’s 25bp repo rate hike late on June 11
was aimed at controlling inflation expectations. In India, fuel subsidies also
suppress inflation and widen the fiscal and current account deficits. Therefore,
we believe that policy rates have not peaked in India. At some point, the economy
would have to factor in rising oil prices and raise rates. At that point, oil prices
may also moderate as the “price mechanism” that is clogged right now by subsidies
in emerging markets begins to work. Nonetheless, our sense is that rates may
yet go up in 2009. In the near-term, however, we expect only one more 25bp
rate hike in 3Q08.
Twin deficit scare and implications for ratings
India’s current account deficit is likely to widen sharply to 2.7% of GDP in FY2008
(and 1.8% of GDP estimated in FY2007) from around 1%-1.2% of GDP in preceeding
years. The central government’s fiscal deficit might exceed the budgeted 2.5%
of GDP by as much as 1.5%-pts on account of expenses related to central government
pay revisions, farm loan waiver and duty cuts to control inflation. This calculation
doesn’t include off-budget oil bonds issued to oil companies which amounts to
another 1.7% of GDP. However, unlike South East Asian countries, deficits are
funded with domestic savings in India. India’s external debt stands at only 17%
of GDP. The banking sector is also a captive market for government bonds as
banks are required to hold 25% of their assets in cash or government bonds as
part of the statutory liquidity reserve requirement. Therefore, the higher fiscal
deficit, by itself, should not materially hurt the balance of payments, leading to
a spiral of weaker currency and higher deficits. India also has the scope to raise
corporate taxes in the short-term to fund higher subsidies - a bad move from a
policy perspective but one that will help the ruling Congress-led coalition reach
general elections in mid-2009 without virtually ensuring its doom. As long as oil
prices do not rise further, we think ratings agencies are likely to give India the
benefit of the doubt, seeing the present fiscal slippage as a temporary setback.
Note:
Annual and quarterly forecasts / references in the text and the table refer to
calendar year forecasts unless specified as fiscal year (FY).
98

Economics – Markets – Strategy
Economics: India
India Economic Indicators
2007** 2008(f) 2009(f) 1Q08 2Q08(f) 3Q08(f) 4Q08(f) 1Q09(f) 2Q09(f)
Real output (99/00P)
GDP 9.0 8.6 8.6 8.7 8.9 8.6 8.6 8.5 8.6
Agriculture 4.5 2.8 3.0 2.9 4.6 3.4 0.8 2.8 3.0
Industry 8.1 6.7 8.7 5.8 6.2 6.7 6.3 7.3 8.1
Services 10.8 10.5 9.9 11.2 10.2 10.5 11.0 10.5 10.2
Construction 9.8 13.4 10.9 12.6 17.2 12.2 15.2 9.3 10.1
External (nominal)
Merch exports (USD bn) 160 200 239 45 46 49 49 56 56
- % YoY 25 25 20 27 29 30 18 24 21
Merch imports (USD bn) 250 321 385 68 82 76 82 82 90
- % YoY 31 28 20 41 45 30 22 19 9
Trade balance (USD bn) -90 -121 -146 -23 -36 -27 -32 -26 -34
Current a/c balance (USD bn) -21 -35 -41 -3 -18 -7 -10 0 -12
% of GDP -1.8 -2.7 -2.8 n.a. n.a. n.a. n.a. n.a. n.a.
Foreign reserves(USD bn, eop) 180 329 345 n.a. n.a. n.a. n.a. n.a. n.a.
Inflation
WPI inflation (% YoY) 4.6 6.8 4.9 5.7 8.3 9.0 6.7 3.4 1.8
Manfg WPI (% QoQ, saar)*** 5.2 7.6 6.0 10.5 13.3 5.5 5.5 5.9 6.0
Other
Nominal GDP (USD tn) 1.2 1.3 1.5 n.a. n.a. n.a. n.a. n.a. n.a.
Fiscal deficit (% of GDP) -3.0 -4.0 -4.0 n.a. n.a. n.a. n.a. n.a. n.a.
Money supply(M3, annual avg) 20 21 22 n.a. n.a. n.a. n.a. n.a. n.a.
* % growth, year-on-year, unless otherwise specified
** Annual data refers to fiscal years beginning April of calendar year.
*** Used as a proxy for core by the RBI
IN – nominal exchange rate
INR per USD
44
44
43
43
42
42
41
41
40
40
39
6/11/2007 10/10/2007 2/8/2008 6/10/2008
IN – policy rate
%, rev repo rate
8.0
7.0
6.0
5.0
4.0
Feb-01 Jul-02 Dec-03 May-05 Oct-06 Mar-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
99

Economics: Indonesia
Economics – Markets – Strategy
ID: Fingers crossed
• The government’s decision to raise subsidized fuel prices despite looming
elections bodes well. It is another step towards long-term fiscal
sustainability, following the fuel price hike of 2005
• But larger price adjustments will have to be made in the coming months.
Even doubling the price of subsidized fuel prices is likely to leave the
subsidy:GDP ratio above the government’s threshold of 3%
• Until further policy action is taken, the rupiah and other Indonesian market
prices could remain under pressure. The May fuel hike will slow growth
to 6.0% this year. It will also add to already-high inflation; this year
headline CPI will rise to 10.3%, before cooling to 7.2% next year. Such
would provide cause for Bank Indonesia (BI) to lift its (new) overnight
benchmark interest rate by a further 75bps to 9.25% by end-3Q08
• Further fuel price adjustments would mean downward revisions to our
growth forecasts, and higher inflation and interest rate projections.
Nonetheless subsidy cuts should be interpreted as a positive for the
country’s fiscal balance and macro fundamentals and should boost foreign
sentiment toward the country
INDONESIA
Subsidized fuel
prices were lifted
28.7% in late May
Subsidized fuel prices lifted nearly 30% in May
On May 24, the Indonesian government announced for the first time in almost
three years that it would raise the price of subsidized fuel. Prices of fuels used
by households and consumers were upped by an average of 28.7% (fuel for
industrial use is not subsidized), with premium fuel 33% more expensive at IDR
6,000/ltr, diesel lifted by 28% to IDR 5,500/ltr and kerosene by 25% to IDR 2,500/
ltr. The hike in subsidized prices had been flagged for some months, and given
the pressure of higher oil prices on the country’s budget deficit – crude had
touched a new high of above USD 135/bbl just two days prior – an adjustment
in subsidized prices was inevitable.
With the country importing significantly more refined oil than what it exports
in crude oil (almost 60 times more in 2007, to be exact – Chart 1), the rise in oil
prices had made subsiding fuel prices at home increasingly untenable. For example,
our estimates indicate that for every liter of IDR 4,500 subsidized premium fuel
enjoyed by Indonesians, the government was shouldering a subsidy burden almost
twice that, by buying refined oil at world prices and selling the same at home at
subsidized levels (Chart 2).
Had fuel prices not been adjusted, our calculations suggest that this year’s budget
deficit would have come close to 2.2% of GDP, a seven-year high. More significantly,
the fuel subsidy would have amounted to some 3.3% of GDP – the highest since
2005, and busting the administration’s unwritten rule that the subsidy:GDP ratio
not exceed 3%.
But much more needs to be done
So, kudos to the government for making the politically tough decision to lift
subsidized fuel prices - in contrast to the circumstances surrounding the (much
Lim Su Sian • (65) 6878 1740 • limsusian@dbs.com
100

Economics – Markets – Strategy
Economics: Indonesia
Chart 1: Indonesia's net oil & gas position
USD mn
15000
10000
5000
Chart 2: 'Market' versus subsidized premium px
IDR/ltr
14000
12000
10000
8000
Latest: Apr08
Oct05 subsidy cut
subsidy
burden
0
-5000
-10000
-15000
Gas
Refined oil
Crude oil
Oil & gas net exports
1998 2000 2002 2004 2006
6000
4000
2000
0
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
Theoretical 'mkt' px (based on Nymex)
Premium fuel
larger) fuel price hike of Oct 2005, President Yudhoyono is not fresh from winning
a landslide victory at the polls, but is instead heading into another election in
June 2009. The fuel price hike also came on top of rising food inflation – in April
fresh food prices were up almost 16% YoY, and around 9% for processed food.
In 2005, food prices had averaged around 7% YoY prior to the fuel price hike.
But we don’t think the government’s work is finished yet, and the real political
test could come in the months ahead. Following the May fuel price hike, government
officials expect this year’s budget deficit to be contained between 1.8-2.0% of
nominal GDP. According to our estimates*, this is entirely achievable – but only
if for the remainder of the year crude oil averages USD 115/bbl or less (around
USD 110/bbl for the full year), or if the rupiah does not weaken beyond 9,550 to
the dollar (9,4000 per dollar for the full year) (Table 1). (In the year to date
Nymex has averaged USD 107/bbl, while USD/IDR has averaged around 9,250.)
Deficit:GDP ratio
will be contained at
1.8-2.0% - only if
crude averages
USD 115/bbl or less
in 2H08
If the subsidy:GDP ratio – and not the deficit:GDP ratio – is actually the more
important, then crude oil must average even lower. According to government
officials we spoke with earlier this year, there is an unwritten government mandate
Table 1: Deficit scenarios after May fuel price hike (def % of GDP)
2008 USD/IDR
Nymex 1mth 9100 9200 9300 9400 9500
95 1.5 1.5 1.6 1.6 1.6
100 1.7 1.7 1.7 1.8 1.8
105 1.8 1.8 1.9 1.9 2.0
110 2.0 2.0 2.0 2.1 2.1
115 2.1 2.2 2.2 2.3 2.3
120 2.3 2.3 2.4 2.4 2.5
125 2.5 2.5 2.5 2.6 2.6
130 2.6 2.7 2.7 2.8 2.8
135 2.8 2.8 2.9 2.9 3.0
that the subsidy:GDP ratio not rise above 3%. Indeed, this appeared to be a
trigger point for government policy action three years back – if not for the
steep 126% hike in subsidized fuel prices in October 2005, the subsidy:GDP ratio
would have been much higher than the reported 3.4% for the year (Chart 3).
Going by that rule, then crude would need to averaged below USD 103/bbl for
the second half (or USD 105/bbl for the full-year), if USD/IDR remains within the
8,950-9,550 range (Table 2).
101

Economics: Indonesia
Economics – Markets – Strategy
The government
will struggle with
its deficit; oil
rationing programs
will not be
effective
In short, unless oil prices ease
at least 10% in the near term
and hold at those levels, and/
or the rupiah appreciates, the
government is only just keeping
its head above water where
its fiscal thresholds are
concerned. To a degree, plans
to ration fuel consumption
via the use of smart cards will
help ease the total subsidy
burden. But this program will
be rolled out only from
September, and will reportedly
only be introduced in Jakarta
and surrounding areas in Java.
It remains to be seen how
effective this system will be
at curbing consumption, and
Chart 3: Deficit/subsidy to GDP
% of GDP
4
3
2
1
0
2003 2004 2005 2006 2007
Oil sub % of GDP
Subsidized
fuel prices
lifted
126%
Budget balance % of GDP
even smuggling activity – the larger the subsidy on a good, the larger the distortion
on consumption behaviour. Indeed, even after fuel prices were hiked a senior
energy ministry said that consumption of subsidized gasoline is likely to rise by
over 5% this year, to 20.4mn kilolitres. Next year, subsidized diesel oil consumption
is expected to increase by 6%, to 12.6mn kl from an estimated 11.9mn kl this
year.
Table 2: Subsidy scenarios after May fuel price hike (sub % of GDP)
2008 USD/IDR
Nymex 1mth 9100 9200 9300 9400 9500
95 2.5 2.5 2.6 2.6 2.7
100 2.7 2.7 2.8 2.8 2.9
105 2.9 2.9 3.0 3.0 3.1
110 3.1 3.1 3.2 3.2 3.3
115 3.3 3.4 3.4 3.5 3.5
120 3.5 3.6 3.6 3.7 3.7
125 3.7 3.8 3.8 3.9 3.9
130 3.9 4.0 4.0 4.1 4.1
135 4.1 4.2 4.2 4.3 4.3
Further hikes in
subsidized fuel
prices cannot be
ruled out
Ultimately, nothing will alleviate the strain on Indonesia’s deficit – or curb the
consumption of subsidized fuel - as quickly or directly as cutting subsidies. And
this might just be the path Indonesia will continue to take. To its credit, since
implementing the fuel price hike in May, the government has repeatedly emphasized
that it could not rule out further increases in fuel prices ahead of next year’s
Presidential elections.
How much will fuel prices have to be further lifted by? As it stands, even after
the May hike, domestic prices are still significantly below global market prices.
For example, subsidized premium fuel now sells for IDR 6,000/ltr; if we make
the conventional assumption that crude oil accounts for half the pump price,
then theoretically premium fuel should be retailing at above IDR 13,000! Needless
to say the government would never consider scrapping fuel prices all at one go,
particularly not when the elections are less than a year away. But our simulations
suggest that the government may have some really tough decisions to make in
the months ahead if things turn ugly - if we assume a crude oil average of USD
102

Economics – Markets – Strategy
Economics: Indonesia
135/bbl for the rest of the year and a USD/IDR average of 9,550, then doubling
subsidized fuel prices as early as Sept08 would still leave the subsidy:GDP ratio
at 3.1%. If we assume prices remain close to current levels, ie. crude at USD 130/
bbl and USD/IDR at 9,350, then doubling prices would bring the subsidy:GDP
ratio to 3%.
In the mean time, growth will cool
The May fuel price hike will moderate activity, and to that end we have shaded
our growth forecasts lower, to 6.0% this year and 6.3% for 2009. Our previous
projections had been at 6.3% for 2008 (unchanged from 2007) and 6.5% for
2009.
We look for growth
of 6.0% and 6.3%,
in 2008 and 2009
Admittedly growth has held pace so far, with GDP rising 6.3% YoY in the first
quarter, unchanged from 4Q07. We think this pace of growth might hold even
in 2Q08. Come the second half, however, a triple combination of higher fuel
prices, higher inflation and higher interest rates will result in a relatively pronounced
slowdown in growth, to a slightly sub-trend average of 5.7% YoY (Chart 4).
Chart 4: Slowdown in 2H08
%-pt contrib to YoY GDP growth
8
7
6
5
4
3
2
1
0
-1
-2
-3
Mar-06 Dec-06 Sep-07 Jun-08
DBSf 08: 6.0%
Pte cons Govt cons Investment
Net exports GDP YoY
Chart 5: Higher inflation this year
% YoY
20
18
Headline CPI
16
14
12
Core CPI
10
8
6
BI target
4
2
Jan-05 Jan-06 Jan-07 Jan-08
DBSf
10.3
8.6
Inflation, interest rates will rise
Prior to the fuel price hike, inflation was already accelerating on higher food
and energy prices, with headline CPI up at a one and a-half year high of 9% YoY
in April. Naturally, the fuel price hike will exacerbate already-high inflation.
Come June, when the impact of the fuel price hike will be more fully felt, we
expect inflation to rise to around 12% YoY. In the months thereafter, inflation
will remain above 11% YoY, taking full-year inflation to 10.3%. This is well
above inflation of 6.4% in 2007, and the central bank’s inflation target of 4-6%
for the year. Next year, inflation should ease to 7.2%, but this will still exceed
BI’s target of 3.5-5.5% (Chart 5). To be sure, inflation particularly this year will
be largely supply-driven. However, there are also some demand-pull factors at
play, as evidenced by strong import growth and the likelihood that growth this
year will remain at, rather than below, trend.
The fuel price hike
will bump alreadyhigh
inflation up to
10.3% this year,
and 7.2% next
year, exceeding BI
targets
To cap these pressures and also cool expectations of future inflation, we think
the central bank BI is likely to lift its (new) overnight benchmark interest rate by
a further 75bps by end-3Q08, to 9.25%. Up until June 8 the operational target
had been the 1-month SBI rate. Judging by BI’s two rate hikes since early May –
ahead of the fuel price hike – BI has displayed a preference for moving in 25bp
moves, small steps by historical standards. The way inflation is set to pan out,
103

Economics: Indonesia
Economics – Markets – Strategy
we see no harm in BI tightening in larger doses of 50bps. However, owing either
to caution over the growth outlook and/or a desire to avoid appearing that it is
in a panic over inflation, the central bank will likely continue moving in 25bp
steps, unless there is a significant decline in the rupiah or inflation starts to
surprise far beyond expectations.
Consumer the first victim
Higher fuel prices, higher inflation and higher borrowing rates will take the
most immediate toll on consumer spending. Private consumption expenditure
(PCE) growth this year should still match last year’s 5.0% pace, but this will owe
largely to above-5% growth in the first half. In 2H08, PCE growth will probably
average 4.5% YoY. Prior to the fuel price hike, rising inflation had already eaten
noticeably into consumer confidence, which as of Apr08 is at two-year lows
(Chart 6). Higher fuel prices and higher interest rates should also moderately
dampen consumer demand for motor-vehicles.
Chart 6: Inflation rising, c'ser confidence falling
Index
% YoY
130
0
C'ser conf
2
120
CPI YoY (RHS, inv)
4
110
100
6
8
10
90
80
12
14
70
60
Latest: Apr08
16
18
20
Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08
Chart 7: Food PCE due for an adjustment
Raw and processed fd, wtd ave
% YoY % YoY
5
4
3
2
1
0
Food inflation (inv, RHS)
Real food PCE
DBSf
Latest: 1Q08
Mar-01 Sep-02 Mar-04 Sep-05 Mar-07 Sep-08
0
2
4
6
8
10
12
14
16
18
20
Food PCE may be
due for a long
downward
adjustment
Even food PCE – almost half total consumer spending – looks set for a slowdown.
Despite the run-up in food prices since 2007, real spending on food has only
accelerated. This might have been fuelled by the improvement in real wage
growth last year, to 4-5% YoY by our estimate. However slower economic activity
overall may mean that nominal wages won’t rise as much as last year; even if
they did, high inflation will erode much of those gains. Meanwhile the rise in
food prices will probably become more pronounced in 2H08; back in 2005 there
were clearly pass-through effects between higher subsidized fuel prices and
food prices (Chart 7). Indeed, if higher food prices are here to stay for the
medium-term (as organizations like the World Bank have concluded), then the
downward adjustment in food PCE growth could drag out for longer than
compared to non-food spending.
Investment will slow on higher input, borrowing costs
Public-private
projects will keep
investment growth
decent
In contrast to consumption, investment growth will be stronger than last year,
at 11% versus 9.2%. Nevertheless on a quarterly basis it looks to us like investment
growth may have already peaked in 1Q08. Spending on building and equipment
surged 13.3% YoY in the first quarter, having accelerated at an almost uninterrupted
pace since 3Q06. However, in the coming quarters private firms are likely to
increasingly postpone their investment decisions, amid a more benign growth
outlook, surging input costs and rising borrowing costs (Charts 8, 9). That said,
the slowdown in investment growth is not going to be drastic (we’re still talking
nearly 9% YoY by year-end), thanks in part to the continuance of public-private
infrastructure projects.
104

Economics – Markets – Strategy
Economics: Indonesia
Chart 8: Investment credit to slow on rate hikes
% YoY %
30
25
20
15
10
5
0
Latest: BI rate
Jun08; credit
1mth SBI (RHS)
DBSf
Investment
credit
Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08
6
7
8
9
10
11
12
13
14
Chart 9: Export prices up, but so are import prices
% YoY
35
30
25
20
15
10
5
0
-5
-10
-15
Wholesale
expt px
Wholesale
impt px
Latest:Mar08
Jan-01 Jan-03 Jan-05 Jan-07
Looking at the medium to long-term, once the economic – and even fiscal uncertainty
clears – rapid investment growth should return. Amid improvements to the
investment climate, there has already been a significant build-up of investment
interest in the country both domestically and overseas since 2005, as evidenced
by the continuing surge in investment applications. Last year, foreign applications
totalled USD 40.1bn (excluding the oil & gas and banking & insurance sectors),
three times the amount in 2005. Domestic applications totalled USD 20.6bn,
four times the amount in 2005. These are investments that will get realized in
the next 1-3 years.
Investment interest
the country could
rise even further,
if national budget
priorities are set
straight. Prior to
the May subsidy cut,
budget figures
showed that a
whopping 24% of
budget spending
was slated for
subsidies this year,
in contrast to just
2% on health, 3%
on public works and
5% on education
(Chart 10). Naturally,
reductions in the
Chart 10: Budget expenditure breakdown, 2008 (pre-subsidy cut)
% of total budget spending
Other govt
agencies
24%
Subsidies
24%
Public works
3%
Int payments
10%
Health
2% Defense
3%
Education
5%
Regional
transfers
29%
country’s subsidy burden via fuel price adjustments will free up a significant
amount of funds for other areas of expenditure that can help improve the investment
climate, such as infrastructure spending.
Net exports will not contribute much
Meanwhile, net exports will add a negligible 0.1%-pts to overall GDP growth.
Export growth has admittedly been stronger than we initially anticipated, up
15% YoY in 1Q08 on robust demand for commodities. However, we are still
looking for global growth to slow this year; in Asia, risks to the growth outlook
are also emerging from rising energy and food inflation. The likelihood is therefore
for export growth to lose some steam in the quarters ahead on a YoY basis,
though shipments should still outpace last year’s, at almost 12% versus 8%.
Subsidies eat up an
huge proportion of
government
expenditure that
could be better
spent on improving
infrastructure
Net exports will
contribute just
0.1%-pts to overall
growth
105

Economics: Indonesia
Economics – Markets – Strategy
Imports will rise at an even faster 14.4%, eating into the trade surplus. Import
growth has also been stronger than expected this year, up 16.8% YoY in 1Q08
and reflecting strong domestic demand for raw materials and capital goods. In
the quarters ahead, though, we expect this to slow, mirroring the likely moderation
in investment growth.
Further fuel price
adjustments should
be interpreted as a
longer-term
positive
Further fuel price hikes… or not
Should oil prices continue to stay elevated, investors will want to see the government
make further adjustments to subsidized fuel prices. This could be done in one
big step (unlikely if before next year’s elections), or several small steps. To buy
itself some time until it is ready to significantly adjust price levels (till, say, after
the elections), it could even index subsidized fuel prices to global levels, rather
than keep prices of subsidized fuels at fixed levels. Such would keep the absolute
amount of the subsidy burden steady, and in turn contain deficit ratios within
acceptable limits.
Naturally, following further fuel price adjustments our growth forecasts will
have to be trimmed, while our inflation and interest rate forecasts will have to
be raised. These changes will depend on the magnitude and timing of the subsidy
cuts. Still, any fuel price adjustments should be interpreted as a positive – every
fuel subsidy cut brings the country one step closer towards the elimination of
subsidies altogether, which will remove significant stress and uncertainty on
the country’s finances, and will also result in resources being allocated much
more efficiently.
The risk in the coming months is a delayed - or worse, absent - government
response amid a continued rise in oil prices. Such would intensify investor concerns
over the budget deficit, putting the rupiah at risk of further weakness. Probably
not quite as weak as the 10,400 level against the USD as we saw in 2005, given
that the level of foreign reserves have almost doubled since. But weak enough
to push BI into defending the currency via more aggressive rate hikes than we
have currently factored in.
Notes
* For details on our methodology, please refer to our focus note, “Indonesia:
Oil and the budget - discomfort levels”, November 21, 2007
106

Economics – Markets – Strategy
Economics: Indonesia
Indonesia Economic Indicators
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Output and Demand
Real GDP growth 6.3 6.0 6.3 6.3 6.3 5.8 5.6 6.1 6.3
Private consumption 5.0 5.0 5.3 5.5 5.4 4.6 4.4 4.9 5.2
Government consumption 3.9 6.1 6.8 3.6 7.5 8.0 5.0 11.0 8.0
Gross fixed capital formation 9.2 11.0 9.4 13.3 12.3 10.2 8.7 9.0 9.5
Net exports (IDRtrn, 00P) 181.5 184.3 190.8 52.9 48.3 37.3 45.9 54.0 47.7
Exports 8.0 11.9 8.2 15.0 12.4 10.2 10.3 8.4 7.8
Imports 8.9 14.4 9.2 16.8 15.3 14.1 11.8 10.0 9.8
External
Merch exports (USDbn) 114 144 164 34 37 36 38 40 41
- % chg 13 26 14 31 30 23 22 18 13
Merch imports (USDbn) 74 103 118 23 27 26 26 28 31
- % chg 22 38 15 50 50 30 25 21 15
Merch trade balance (USD bn) 40 42 46 10 10 10 12 12 10
Current account bal (USD bn) 11.8 13.3 14.5 3.8 3.5 2.8 3.2 4.0 3.5
% of GDP 2.7 2.7 2.7 n.a. n.a. n.a. n.a. n.a. n.a.
Foreign reserves (USD bn, eop) 57 60 66 n.a. n.a. n.a. n.a. n.a. n.a.
Inflation
CPI inflation 6.4 10.3 7.2 7.5 10.3 11.7 11.4 9.7 7.5
Other
Nominal GDP (USDbn) 433 484 546 n.a. n.a. n.a. n.a. n.a. n.a.
Budget deficit (% of GDP) -1.5 -2.3 -2.5 n.a. n.a. n.a. n.a. n.a. n.a.
Total external debt (USD bn) 137 143 146 n.a. n.a. n.a. n.a. n.a. n.a.
% of GDP 32 30 27 n.a. n.a. n.a. n.a. n.a. n.a.
* % change, year-on-year, unless otherwise specified
ID – nominal exchange rate
IDR per USD
9,580
9,440
9,300
9,160
9,020
8,880
8,740
6/11/2007 10/10/2007 2/8/2008 6/10/2008
ID – policy rate
%, 1 mth SBI rate
19.0
17.0
15.0
13.0
11.0
9.0
7.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
107

Economics: Malaysia
Economics – Markets – Strategy
MY: Biting the bullet
• Prime Minister Badawi finally announced the much anticipated restructuring
of the energy subsidy program
• Malaysia is expected to remain a net exporter of crude oil until 2014 and
current restructuring is expected to bring about longer-term fiscal
sustainability and economic efficiency
• However, the subsidy cuts are expected to stoke inflation and cause growth
to slow
• Inflation will peak at 5.8% in Jun08 and is set to average 4.5% for the full
year. Our inflation forecast for 2009 has also been lifted to 3.3%
• We expect Bank Negara to hike the policy rate by 50bps at the next policy
meeting in July, to anchor inflation expectations and to prevent secondround
effects of inflation
• Growth is expected to moderate to 5.1% for the year. Our 2009 growth
forecast has also been trimmed to 5.8%
MALAYSIA
The restructuring
of Malaysia’s
energy subsidy
program is
expected to save
the government
some MYR 13.7bn
Revision to the
subsidy program
will negatively
impact consumers
Short term pain, long term gain
After weeks of speculation, Prime Minister Badawi finally announced the much
anticipated restructuring of the fuel subsidy program. The changes, effective
June 5, have lifted petrol prices by 41% to MYR 2.70/ltr, and diesel prices by
MYR 1 to MYR 2.58/ltr. Prices will be reviewed on a monthly basis hereafter. In
addition, power tariffs for commercial users will rise by 26% while Tenaga will
introduce a new power-tariff structure from 1 July. Prices of gas supplied by
Petronas will also double as part of this restructuring process. All in, the restructuring
process is expected to help the government save about MYR 13.7bn this year.
Separately, to further shore up its revenue, the government is also imposing a
windfall tax of 5%-15% on palm oil millers, for crude palm oil priced above
MYR 2,000 per metric ton.
The revision to the subsidy Chart 1: Higher oil prices lifted oil trade balance
program will help to improve MYR mn
USD/bbl
the government’s fiscal
140
position, but not without
Oil trade balance
6000
short-term detrimental effects
Oil prices
120
on consumers. In order to
5000
soften this impact, particularly
100
for the lower income group,
the government will offer
cash rebates for the first 800
litres of petrol used by owners
4000
3000
80
60
of small cars and motorcycle. 2000
This is equivalent to a rebate
40
of about MYR 625 for the
year for owners of cars below
2000cc, and MYR 150 for
1000
0
20
0
motorcycles. Road tax for
cars below 2000cc will also
Jan-99 Jan-01 Jan-03 Jan-05 Jan-07
be lowered by MYR 200. Furthermore, some of the savings from the new measures
will be diverted to food subsidies to benefit the poor more directly.
Irvin Seah • (65) 6878 6727 • irvinseah@dbs.com
108

Economics – Markets – Strategy
Economics: Malaysia
The reforms to the fuel subsidy program is a positive for medium-term fiscal
sustainability, and will mean better resource allocation. Admittedly, unlike Indonesia,
which recently also reduced fuel subsidies, Malaysia is a net exporter of oil and
related products, and on the surface there appears to be no reason why higher
oil revenues cannot be used to indefinitely maintain fuel subsidies. As is clear
from Chart 1, Malaysia’s trade surplus in
oil has escalated in line with crude oil prices,
coming to MYR 38bn last year. According
to the domestic trade minister, the economy
earns MYR 250mn a year in revenue for
every USD 1 increase in crude prices.
In this context, one can understand why
the hike in fuel prices left Malaysians fuming
and baffled. They were expecting an increase,
but not as high as 41%. Critics also pointed
out that after the price adjustments, Malaysia
now has the highest domestic petrol prices
among the net petroleum-exporting countries
(Table 1).
But all these arguments ignore the likelihood that Malaysia will become a net
oil importer in 2014, given the current trend in oil demand and its existing oil
reserves. The fuel subsidy would also have cost the government as much as MYR
56bn this year (based on current crude oil prices of about USD 130/bbl), or about
a third of government expenditure in 2008, had prices not been adjusted. Even
after the subsidy cuts, the government expects a budget deficit of about 3.1%
of GDP this year. This is not a high number, but it would be if Malaysia turns
into a net importer of oil and energy subsidies have not been adjusted.
In addition, the fuel subsidy program is regressive and tends to benefit the rich
more than the poor. Subsidies also distort market mechanisms; by artificially
keeping prices low, demand for fuel is higher than what it would be, had prices
been allowed to adjust. It results in wasteful consumption and encourages smuggling,
due to the gap between international and domestic prices. Thus, resources are
not well allocated to those who need the fuel the most, and inefficiency sets in.
Still, while reducing subsidies will bring about long-term gains for Malaysia in
the form of a more competitive
and efficient economy, some
short-term pain will have to
be endured.
Inflation set to rise
The most obvious and
immediate impact on the
economy would be higher
inflation. Our estimation shows
that for every 10% increase
in fuel prices, month-on-month
inflation will rise by 0.7%-
pts. The main increase should
come from the transport and
HW (housing, water, electricity,
gas and other fuels) sectors.
With that, overall CPI inflation
should rise sharply to about
5.8% YoY in June, lifting full
Table 1: Petrol prices in selected oil
producing countries
Country
Domestic petrol prices
(MYR/litre)
Malaysia 2.70
Indonesia 1.86
Saudi Arabia 0.38
Iran 0.35
Nigeria 0.32
Turkmenistan 0.25
Venezuela 0.16
Chart 2: Policy tightening needed to tame inflation
% YoY
7.3
DBSf
6.3
5.3
4.3
3.3
2.3
1.3
Inflation
OPR
Fuel subsidy cut
50bps rate hike
Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08
year inflation to about 4.5% (Chart 2). Inflation for 2009 will be around 3.3%,
up from our previous 2.0% forecast as the inflationary impact spills over to
1H09.
Its all about
medium term fiscal
sustainability and
better resource
allocation
Inflation is
expected to rise
sharply to 4.5% for
the full year
109

Economics: Malaysia
Economics – Markets – Strategy
Bank Negara to
hike the policy rate
50bps in 3Q08, to
4.0%
Policy action needed
Higher inflation will push real interest rates towards negative territory, if they
are not already there (Chart 3). Adjusted for inflation, real deposit rates were at
-1.63% in Apr08. Real policy rates and lending rates will most likely fall further
if inflation spikes to 5.8% in June on the fuel price hike. A negative real interest
rate scenario favours borrowers, and risks fuelling asset inflation. As general
prices rise, so could inflation expectations, resulting in even higher inflation
going forward. For example, if workers demand higher wages in anticipation
of further price increases, it will inevitably set off a second round of price increase.
Thus, policy action is needed now to anchor inflation expectations, and to prevent
second-round inflationary effects. We expect Bank Negara to hike the policy
rate by 50bps at the next policy meeting in July (Chart 2), taking the Overnight
Policy Rate to 4%. In fact, while no policy meeting is planned for June, we do
not discount the possibility of an inter-meeting hike. In addition, while the
inflationary effects of the fuel price hikes are expected to be transient and will
likely wear off after 12 months, the government has hinted that this may just
be the first of a string of subsidy cuts. Overall, inflationary pressure will remain
high amid risks of higher global commodity prices and further hikes in subsidized
fuel prices. The central bank sounded hawkish in its most recent policy statement,
and we believe the rhetoric will remain so in the next few quarters given the
outlook on inflation.
Chart 3: Real interest rates heading south
%, % pa
6
5
4
Real policy rate
Real deposit rate
Real lending rate
3
2
1
0
-1
-2
-3
-4
Latest: Apr08
Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07
Chart 4: Growth likely to moderate
%-pt contribution
20
15
10
5
0
-5
-10
Net exports
Investment
Govt expenditure
Pvt consumption
GDP growth
Latest: 1Q08
Mar-05 Mar-06 Mar-07 Mar-08
Growth will be affected
The impact on growth will be mixed. Although savings from the subsidies can
be used to stimulate growth, we think that this is more likely to happen in the
longer term than in the near term. In fact, the government has not publicly
explained how the savings from the subsidy cuts will be used. While we assume
that effort will be put into upgrading the existing transport network, work will
probably start at a later stage and benefits will only be reaped in the longer
term.
In the near term, domestic demand will be most affected by the fuel price hike.
In particular, private consumption, which registered robust growth of 11.6%
YoY and contributed 3.6%-pts to overall GDP growth, is expected to moderate
to an average of 7.3% for the full year (Charts 4 and 5). Government expenditure,
which grew by a robust 10.5% YoY in 1Q08 (making a 0.7%-pt contribution to
110

Economics – Markets – Strategy
Economics: Malaysia
growth) will also be shaved. We reckon that growth in government spending
could slow to an average of 5.5% for the year, as the government cuts down on
its energy subsidies. Delays or postponements of some government projects due
to political differences between the Federal and opposition state governments
may further complicate matters and slow down the disbursement of government
funding. Investment growth will likewise be affected. Capital investment rose
6.0% YoY and contributed 0.8%-pts to overall growth in 1Q08. Given ongoing
political uncertainty, a moderation in the growth outlook as well as possibly
higher interest rates going forward, investment growth will probably taper off
to an average pace of 5.7% for the year.
Domestic demand
will be most
affected
The slowdown in domestic demand will be compounded by an anticipated decline
on the external front. Although net export growth has been higher than expected
at 26.4% YoY in 1Q08, it was underscored by a low base in the same period last
year and helped by much slower import growth of 3.4%. Overall export growth
in fact moderated to 6.0% YoY in 1Q08, down from 7.8% YoY in the previous
quarter.
Chart 5: Domestic demand set to moderate
% YoY
16 Pvt consumption Govt expenditure
14
Investment
DBSf
12
10
8
6
4
2
0
Mar-05 Mar-06 Mar-07 Mar-08
Chart 6: GDP growth forecast revised down to
% YoY
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
GDP
GDP growth (previous)
GDP growth (latest)
Mar-05 Mar-06 Mar-07 Mar-08
MYR mn
150000
140000
130000
120000
110000
100000
90000
80000
70000
60000
While the underlying fundamentals of the Malaysian economy have been strong,
near-term downside risk to growth remains high. The broader weakness in global
demand is expected to continue weighing on export-oriented sectors. The domestic
segment will be affected by higher inflation, monetary tightening as well as
sentiment-dampening fuel subsidy cuts. With that, we expect overall GDP growth
to moderate to 5.1% this year, down from our previous forecast of 5.8% (Chart
6). Growth next year is expected to register 5.8%, a tad below our previous
forecast of 6.0% owing to spill-over effects.
Growth is expected
to moderate to
5.1% this year
111

Economics: Malaysia
Economics – Markets – Strategy
Malaysia Economic Indicators
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
GDP growth 6.3 5.1 5.8 7.1 4.8 4.2 4.1 5.3 4.6
Private consumption 11.7 7.8 5.9 11.8 7.7 5.7 5.8 4.9 5.7
Government consumption 6.4 6.9 4.0 10.5 6.3 7.1 3.7 5.0 4.3
Gross fixed capital formation 10.2 5.7 10.7 6.0 5.5 5.3 5.7 9.9 12.2
Net exports (MYRbn, 00P) 77.1 71.6 67.8 20.3 15.9 20.0 15.4 17.4 12.2
Exports 3.7 5.8 7.1 6.0 5.1 4.6 7.6 7.4 7.8
Imports 4.1 6.9 8.8 3.4 6.8 7.1 10.2 10.8 11.3
External (nominal)
Exports (MYR bn) 605 646 701 152 164 161 169 158 177
Imports (MYR bn) 505 544 581 125 135 141 143 132 145
Trade balance (MYR bn) 100 102 120 27 29 21 26 26 32
Current account bal (USD bn) 29 33 38 n.a. n.a. n.a. n.a. n.a. n.a.
% of GDP 15.5 16.1 16.9 n.a. n.a. n.a. n.a. n.a. n.a.
Foreign reserves
(USD bn, yr-end) 99 146 190 n.a. n.a. n.a. n.a. n.a. n.a.
Inflation
CPI inflation 2.0 4.5 3.3 2.6 4.0 5.8 5.6 5.1 4.1
Other
Nominal GDP (USDbn) 189 206 227 n.a. n.a. n.a. n.a. n.a. n.a.
Fiscal balance (% of GDP) -3.2 -3.5 -3.4 n.a. n.a. n.a. n.a. n.a. n.a.
- % growth, year-on-year, unless otherwise specified
MY – nominal exchange rate
MYR per USD
3.60
MY – policy rate
%, OPR
4.0
3.50
3.5
3.40
3.0
3.30
3.20
3.10
6/11/2007 10/10/2007 2/8/2008 6/10/2008
2.5
2.0
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
112

Economics – Markets – Strategy
Economics: Malaysia
This page is intentionally left blank
113

Economics: Thailand
Economics – Markets – Strategy
TH: Politics over economics
• In the first quarter, Thai economy grew by 6% (YoY) and 5.6% (QoQ, saar)
driven by strong export growth and modest recovery in domestic demand
• However, since then, the political situation has deteriorated sharply with
anti-government protests on the rise in Bangkok. In fact, risks of a coup
have risen sharply in May08 / Jun08. In our central scenario, we assume the
current turmoil continues
• The lack of political stability and the rise in cost of living should prevent
any material recovery in domestic demand. Yet, strong economic
fundamentals and competitiveness in manufacturing should keep export
strong. We, therefore, look for 5% and 4.7% GDP growth in ‘08 and ‘09
• There is still sense in reducing the degree of policy accommodation.
Therefore, we have maintained our forecast for rates to be lifted by 50bps
to 3.75% in 4Q08. A 3Q08 rate hike, however, cannot be ruled out.
1Q08 GDP review and summary outlook
Political instability
is likely to hurt
domestic demand
In the first quarter, Thai economy grew by 6% (YoY) and 5.6% (QoQ, saar) driven
by strong export growth, modest recovery in domestic demand and inventory
accumulation. The data particularly reveal Thailand’s export competitiveness -
exports grew by 8.7% (YoY) or 23% (QoQ, saar). Consumption spending expanded
by 5.5% (QoQ, saar) but was weaker than our expectations and unimpressive in
YoY terms (2.6%). Private investment spending grew by 6.5% (YoY) but slowed
down to 1% (QoQ, saar) in sequential terms. Oddly, government spending -
consumption and investment - slowed sharply (Charts 1 & 2).
Going forward, although economic fundamentals are sound, lack of political
stability should hurt domestic demand. This coupled with the rise in cost of
living and worries about higher inflation should keep domestic demand below
potential. Therefore, we recently downgraded our 2008 and 2009 GDP forecast
Chart 1: GDP contribution by expenditure
Chart 2: GDP growth
% YoY
8
6
4
2
0
% QoQ, 2qma
8
6
GDP growth (sequential terms)
THAILAND
-2
-4
-6
-8
Errors
Net Exports
Government
Investment + Stocks
Consumption
GDP
Sep-06 Mar-07 Sep-07 Mar-08
4
Latest: Mar08
2
Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07
Ramya Suryanarayanan • (65) 6878 5282 • ramya@dbs.com
114

Economics – Markets – Strategy
Economics: Thailand
to 5% (vs 5.6% earlier) and 4.7% (vs 5.2% earlier). Domestic demand should still
do much better than the dismal showing in 2007 (assuming we do not actually
see another coup).
No end in sight to political stand-off
We are particularly concerned that there is no end in sight to the political instability
that erupted with anti-Thaksin protests in 2005. As democratic institutions such
as the judiciary and the constitution court were believed to be subverted by expremier
Thaksin, the military justified a coup on the grounds that it is the only
viable solution to non-violently end anti-government protests. Many Thais in
Bangkok even hoped the coup would turn out to be a solution for the political
woes once the military made it clear that this was a temporary move meant to
restore the independence of democratic institutions. Following that, democratic
elections were expected to return stability to the country with the hope that
the Democratic party may return to power. As we know, this did not happen
and political uncertainties have only worsened in 2008. Obviously, staging a
coup again and / or holding fresh elections again will not result in different,
more favourable and stable outcomes. But another coup is certainly a material
risk and would be disastrous for the Thai economy.
One main reason for the return of political instability is that the country is
polarized with people in Bangkok against Thaksin and the (majority) rural Thais
in favour of Thaksin. This means elections are likely to bring some form of
Thaksin’s Thai Rak Thai (TRT) back in power. This, in turn, leads to government
policies and functioning that bring people in Bangkok on streets in anti-government
protests. The charter change agenda is just a policy that has brought out these
deep divisions in the forefront. As such, it appears likely that political uncertainty
is here to stay.
Politics to hurt confidence and consumption recovery
Consumption spending grew by around 3% (QoQ, saar, smoothed) in the last
two quarters, double the rate that prevailed in the preceeding 12 months (Chart
3). Going forward, deterioration in politics implies consumption should stay
below trend (~5%). We expect a continuation of 3% sequential growth ahead
as consumer confidence should begin to deteriorate once again. It is interesting
to note that despite political worries, the “present” and “future” confidence
sub-indices have diverged in the last 12 months (Chart 4). The “future” was
generally expected to be much better than the “present”. In other words a
resolution was always expected for the political woes which were seen as relatively
There is little hope
for an end to the
political stand-off
as elections have
failed to resolve
outstanding issues
Future subcomponent
(Chart
4) of consumer
confidence might
begin to fall
Chart 3: Personal consumption vs avg wages
% YoY % YoY, 2qma
9
8
Chart 4: Consumer confidence - "future" to drop?
Index
98
6
3
0
6
4
2
0
88
78
-3
Mar-
01
Mar-
02
Mar-
03
Mar-
04
Mar-
05
Mar-
06
Mar-
07
Private consumption indicator
Avg wages (RHS)
Mar-
08
-2
68
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08
Consumer confidence: present
Consumer confidence: future
Consumer confidence: future income
115

Economics: Thailand
Economics – Markets – Strategy
short-term. However, as we discussed in the previous paragraph, both the coup
and the general elections have failed to bring political stability, revealing instead
the deep divisions in Thai society at present. This means that confidence that
the political mess can be resolved in the future should begin to fade. This may
drag the “future” confidence sub-index down towards the “present” index at
some point. This, in turn, is negative for the longer term outlook. Thankfully,
we can still count on the relatively healthy labour market and strong farm
incomes in 1Q08 to support consumption spending at around 3%.
Investment - expected only in export oriented sectors where capacity is tight
In 1Q08, investment spending began to turn around (Chart 5) in light of elevated
capacity utilisation rates and pent up demand, especially in export-oriented
sectors. Indeed, business sentiment, especially with regards to investment turned
around sharply according to a BoT survey (Chart 6).
Chart 5: Investment vs capacity utilisation
% YoY %
20
77
Chart 6: Business sentiment: investment sub-index
Index
58
15
10
5
75
73
71
56
54
52
50
0
-5
Gross capital formation
Capacity Utilisation
Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08
69
67
48
46
Mar-00 Mar-02 Mar-04 Mar-06 Mar-08
However, the renewed spike up in political uncertainty implies that further
recovery in investment should be restricted to sectors and companies with very
high capacity utilisation where orders cannot be met unless capacity is expanded.
Capacity utilisation is now running above 90% in some sectors such as electrical
and electronic, food, chemicals and paper (Chart 7). This should help support
investment spending growth at 5%-6%, a little better than the 3% growth seen
in 2006 and 2007, but disappointing nonetheless.
Chart 7: Capacity utilisation - 90% in many sectors even as headline rate is not high
%, 4qma
105
Mar-05
Mar-08
100
95
90
85
80
75
70
65
60
Paper Chem Petro
pdts
IC
Disk
drives
Zinc
Comm.
Car
Tyre
Wshg
Mach
116

Economics – Markets – Strategy
Economics: Thailand
Exports going strong - around 15% if price effect is taken into account
Export growth has accelerated in the last three months. Exports grew by 28%
(YoY) and 20% (3mma) in Apr08. After accounting for higher commodity prices,
manufacturing exports appear to be growing at circa 15% annual rate. This is
illustrated in the chart below. Petroleum products, jewellery, and manufactured
food (bright red bar in the chart), all of which have seen unusually large price
increases, are the key drivers behind the rise in exports in the last six months
(Chart 8). In any case, 15% export growth rate is indeed remarkable considering
that the US struggles with 1% annualised consumption spending.
Accounting for
commodity price
jump still means
Thai export growth
is around 15%
Chart 8: Mfg exports by commodity accounting for commodity price rise
% pt- YoY, 3mma
40
35
30
25
20
15
10
5
Machinery (mainly PC)
Vehicles and parts
Base metal
Oil, jewellery, food (px effect)
Electronics (IC, HDD)
Electrical appliance
All the rest
Mfg exports
0
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08
The 1Q08 GDP report showed that exports in real terms rose by 5.7% (QoQ, sa)
or 23% annualised. Exports expanded at a similar rate in 4Q07. Clearly, Thai
manufacturing sector is competitive in many electrical and (low-end) electronic
products. In the past year, exports to Asia and other emerging markets have
been the key driver of Thai export growth (Chart 9). Furthermore, Asia (ex-Thai)
exports to US has also been very weak (Chart 10). In other words, final demand
doesn’t merely lie in the US and exports to Asia have not been merely recycled
to the US. As such, even as US economic growth is weak, we are confident that
Thai exports should grow at the annual rate of 15% going forward. This should
support full year 2008 export growth at 20%.
Thai exports to
Asia not merely
headed to US
Chart 9: Exports to Asia driving export growth….
% YoY, 3mma
35
30
25
20
15
10
5
0
-5
-10
TH exports: to Asia
Th exports: to US
Apr-06 Oct-06 Apr-07 Oct-07 Apr-08
Chart 10: …and these are not merely headed to US
% YoY, 3mma
35
30
25
20
15
10
5
0
TH exports: to Asia
Asia ex-Thai exports: to US
Apr-06 Oct-06 Apr-07 Oct-07 Apr-08
117

Economics: Thailand
Economics – Markets – Strategy
There is still some
sense in reducing
the degree of
policy
accomodation
Inflation and monetary policy
We recently lifted our 2008 CPI forecast again to 6.4%. Inflation is really a wild
card this year. If we see a big drop in food prices, inflation can decline pretty
rapidly. Conversely, if food and fuel prices increase further or do not decline,
then inflation will be higher than our forecast. In any case, core inflation would
head higher as higher crude oil price results in higher transportation costs which
in turn push the price of nearly all products higher.
We think the BoT would not mechanically react to higher core inflation. Rather,
the key question policy makers will ask is whether this is a one-off increase in
price level or is there a risk of a more permanent increase in inflation. The
answer to this question depends on inflation expectations and strength of domestic
demand. This, in turn, depends on a return to normalcy on the political front, a
normalcy that is not simply a temporary calm before the storm.
The point is that if politics continues to disappoint, then BoT can afford to keep
rates at accommodative levels. However, we think there is sense in reducing the
degree of accommodation at some point. Therefore, we have maintained our
forecast for rates to be lifted by 50bps to 3.75% by end-08 despite downgrading
the GDP forecast. We think it is more likely that this hike comes in 4Q08 than
3Q08. Uncertainties on global growth should ease by fourth quarter and the
degree of domestic demand recovery in Thailand should also be apparent. An
earlier rate hike, however, cannot be ruled out.
118

Economics – Markets – Strategy
Economics: Thailand
Thailand Economic Indicators
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
GDP growth (88P) 4.8 5.0 4.7 6.0 5.7 4.7 3.7 3.5 4.4
Private consumption 1.5 3.3 3.3 2.6 3.6 3.1 3.8 3.0 3.2
Government consumption 10.8 1.7 6.0 -0.1 1.2 1.7 4.1 7.7 6.4
Gross Fixed capital formation 1.4 4.3 6.0 5.4 4.7 4.0 3.3 4.8 5.7
Chg in Stocks (THB bn) 1.8 2.0 3.2 n.a. n.a. n.a. n.a. n.a. n.a.
Net exports (THBbn) 673 786 834 187 151 220 227 186 160
Exports 7.1 10.1 6.1 9 10 14 8 4 6
Imports 3.5 8.1 6.1 10 10 8 5 6 6
External
Merch exports (USDbn) 151 181 203 43 44 48 48 47 49
- % YoY 18 20 12 26 22 24 13 9 12
Merch imports (USDbn) 139 174 195 41 45 43 44 46 50
- % YoY 10 25 12 34 30 21 16 10 11
Trade balance (USD bn) 12 7 8 -1 -1 5 4 1 -1
Current account balance (USD bn) 15 12 13 -1 -1 5 6 5 -1
% of GDP 6.1 3.7 3.4 n.a. n.a. n.a. n.a. n.a. n.a.
Inflation
CPI inflation 2.2 6.4 2.8 5.0 7.0 7.7 5.9 4.1 2.1
Other
Nominal GDP (USDbn) 244 330 384 n.a. n.a. n.a. n.a. n.a. n.a.
Unemployment rate, % 1.0 0.8 1.0 n.a. n.a. n.a. n.a. n.a. n.a.
* % change, year-on-year, unless otherwise specified
TH – nominal exchange rate
THB per USD
34
TH – policy rate
%, 1-day RRP
5.0
33
32
4.5
31
4.0
30
29
3.5
28
6/11/2007 10/10/2007 2/8/2008 6/10/2008
3.0
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
119

Economics: Singapore
Economics – Markets – Strategy
SG: Inflation woes
• Inflation has continued to rise owing to both domestic and external factors
• The effectiveness of exchange rate policy – Singapore’s policy tool – in
containing inflation is limited
• Inflation will remain high for the rest of the year. Full year average inflation
will register 6.4%
• GDP growth in 1Q08 was strong at 6.7% YoY, led by investment,
consumption and government spending. Net exports were a drag
• The next two quarters will see slower growth, led by a declining
manufacturing sector. But full-year growth remains on track to hit 6.0%,
with growth of 6.8% expected in 2009
CPI inflation in April
clocked 7.5% YoY
Inflation continues to escalate
Consumer prices rose by a very fast 7.5% YoY in April (Chart 1). Food price
inflation hit 8.5% while transport and communication prices rose 7.0% as a
result of dearer petrol, as well as higher taxi fares and car prices. Housing costs
spiked 11.8%, driven by higher electricity tariffs and rentals.
Chart 1: Inflation still rising
% YoY
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
Inflation
Core inflation
Inflation hit
7.5% in Apr08
Latest: Apr08 -2
Jan-05 Jan-06 Jan-07 Jan-08
Chart 2: Food inflation may moderate
% YoY
14
12
10
8
6
4
2
0
CPI - food
Domestic supply px index - food
Import px index - food
Latest: Apr08
Jan-05 Jan-06 Jan-07 Jan-08
SINGAPORE
Inflation has continued to rise on the back of both domestic and external factors.
Domestically, the effects of the upward revision to the Annual Values of homes,
hike in taxi fares, ERP charges, higher fuel and car prices will continue to linger
on headline CPI inflation. Externally, although food prices are showing signs of
moderating (Chart 2), crude oil prices have continued to surprise to the upside,
creating tremendous imported inflationary pressure for this small and open
economy (Chart 3). The price of crude oil has already surged beyond USD 130/
Irvin Seah • (65) 6878 6727 • irvinseah@dbs.com
120

Economics – Markets – Strategy
Economics: Singapore
bbl and looks likely to remain there for a while. With supply-side tightness,
strong demand and speculative pressure, energy prices may remain elevated for
the rest of the year.
Chart 3: High oil prices will remain a threat
USD/bbl
140
130
120
110
100
90
80
70
60
50
Oil prices (Brent)
40
Jan-07 Mar-07 Jun-07 Sep-07 Dec-07 Feb-08 May-08
Chart 4: Recent tightening in policy
110
Re-centering of
108
the policy band
106
104
102
100
98
96
94
Modest increase
in slope
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
110
108
106
104
102
100
98
96
94
Exchange rate policy is limited
The central bank clearly understands the risk of rising inflation and its impact
on the broader economy. It has tightened monetary policy twice in the past
year (Chart 4). In its most recent move in Apr08, the Monetary Authority of
Singapore (MAS) re-centred its SGD NEER policy band by moving the centre of
the band to the prevailing NEER level. The width and slope (or appreciation
pace) of the band were left unchanged. Essentially, the original upper limit of
the SGD NEER policy band became the centre of the new band, resulting in a
one-off appreciation of about 1.5% for the SGD NEER.
But the effectiveness of MAS’ exchange rate policy in containing inflation is
limited. The exchange rate policy alone is not the cure-all for inflation. Instead,
it should be viewed merely as a cushion against supply-side pressures, especially
those stemming from high commodity prices. A stronger currency will help to
offset the impact of imported inflationary, but only partially - since the start of
Exchange rate
policy cannot
always contain
inflation
Chart 5: Domestic inflation has been rising too
% YoY
Chart 6: Strong SGD is hurting exports
% YoY SGD/USD
10
20
NODX growth
1.70
15
1.65
8
SGD/USD
Tradable CPI
1.60
10
Non-tradable CPI
6
1.55
5
1.50
4
0
1.45
-5
1.40
2
1.35
-10
1.30
0
-15
Latest: Apr08
1.25
-2
Latest : Apr08 -20
1.20
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08
121

Economics: Singapore
Economics – Markets – Strategy
the year, the SGD has appreciated 6% against the USD, versus an almost 40%
surge in crude oil prices.
The exchange rate policy is also ineffective in stemming domestically-induced
inflation, which we believe Singapore is also experiencing as a result of strong
growth over the last few years. Domestic inflation, as proxied by non-tradable
CPI inflation, has been rising along with imported inflation (represented by
tradable CPI inflation) (Chart 5). Lastly, the exchange rate policy has a significant
flip-side - that of a stronger currency weighing on export growth (Chart 6).
Inflation should moderate but full-year average will remain high
Inflation should
peak at 8.1% YoY in
Jun08
Inflationary pressure will remain high in the near-term. We expect the CPI to
peak at 8.1% YoY in Jun08, which will bring average inflation in 1H08 to 7.2%
(Chart 7). The base-year effects of the GST hike in 2007 will disappear from July,
resulting in a 2%-pt drop in YoY inflation for that month. However, it is unlikely
to bring much comfort, given that the rise in commodity prices is not showing
any sign of abating. Inflation in the second half of the year will therefore likely
remain high, at about 5.6%. With that, full year inflation will register 6.4%, up
slightly from our previous forecast of 6.0%. Our inflation forecast for 2009
remains at 2.8%.
With inflation this year likely to burst through the 5.0-6.0% comfort zone of
policymakers, there is some risk that policy will be tightened further to rein in
inflation. However, based on our estimates inflation will most likely be on its
way down when the central bank next decides on policy in October. Unless
commodity prices - particularly crude oil - continue to surprise to the upside,
the central bank is likely to hold back on tightening policy, given concerns over
the growth outlook in the next few quarters.
Chart 7: Inflation forecast for 2008
% YoY DBSf
9.0
Inflation should
8.0
peak at 8.1% in
7.0
Jun08
6.0
Inflation
5.0
Core inflation
4.0
3.0
2.0
1.0
0.0
-1.0
Jan-05 Jan-06 Jan-07 Jan-08
Chart 8: Net exports still the main drag on growth
%-pt contribution
30
25
20
15
10
5
0
-5
-10
-15
-20
Latest: 1Q08
Net Exports
GFCF
Govt Consumption
Pvt Consumption
GDP Growth
Net exports subtracted
17%-pt from growth
Mar-05 Mar-06 Mar-07 Mar-08
Decent growth in 1Q08
First quarter GDP
growth clocked
6.7%
While the outlook for the next two quarters is not rosy, growth in the first
quarter was decent, with GDP growth clocking 6.7% YoY, led by a robust expansion
in investment. Gross Fixed Capital Formation (GFCF) surged 30% YoY in the
quarter, contributing a chunky 16.5%-pts to overall GDP growth (Chart 8). However,
against the backdrop of slowing global demand, net exports contracted 27.7%
YoY, shaving 17%-pts from growth. While export growth was reasonably strong
at 9.2% YoY, it was offset by even stronger import growth of 13.8% YoY. Private
consumption and government spending also increased, up 4.1% YoY and 3.2%
YoY respectively. Overall, domestic demand has been buffering the Singapore
122

Economics – Markets – Strategy
Economics: Singapore
economy against the decline in external demand. Still, the risks remain biased
to the downside going forward, as we expect the US-led decline in global demand
to weigh on growth in the next two quarters.
Slower growth ahead
The manufacturing sector, which posted a stunning 12.4% YoY expansion in the
first quarter, may bear the brunt of this global slowdown. Already, higher frequency
indicators like industrial output data is pointing to signs of moderation in the
sector (Chart 9). For example, electronics output contracted by about 5.1% YoY
in Apr08 versus a rise of 5.4% YoY in 1Q08. With the US semicon-making equipment
(SEMI) book-to-bill ratio not showing any signs of turning around, it seems that
the tech-sector recovery which many had anticipated would occur in second
half is not going to materialise (Chart 10). Although the biomedical segment
may provide some much needed support from time to time, it is highly volatile
in nature. A good example would be April’s industrial output figure, which fell
5.7% YoY due to a drastic 28% YoY contraction in pharmaceutical output. So,
against the broader backdrop of a slowing global demand, the manufacturing
sector may start to lose steam from the second quarter onwards before a turnaround
in the fourth, on hopes of a recovery in the US.
The manufacturing
sector may lose
steam
Chart 9: Manufacturing set to moderate
index, 3mma
140
130
120
110
Manufacturing
showing signs of
moderation
Chart 10: Electronics not turning around
ratio
1.3
1.2
Latest: Apr07
1.1
1.0
% YoY
40
20
0
100
90
80
70
Pharmaceuticals
Electronics
Overall manufacturing
May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08
0.9
0.8
0.7
0.6
Global semicon sales
SEMI book-to-bill (LHS)
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
-20
-40
-60
But some segments will remain resilient
In the quarters ahead, export-oriented and sentiment-sensitive sectors (such as
manufacturing, and some financial and real estate services) will be more affected
by the deterioration in the external environment and heightened risk aversion
in the asset markets. Domestic and region-oriented sectors such as construction,
marine engineering and tourism should perform better, providing some support
to the economy. In general, economic activity in Asia is expected to remain
fairly resilient in the near term, reflecting strong domestic demand and underlying
growth momentum. Furthermore, Asian financial institutions are also less affected
by the subprime crisis in the US.
Overall, it will no doubt be a challenging year for the Singapore economy, as it
faces the prospect of slower growth and higher inflation. Yet, the underlying
fundamentals of the economy remain strong. Our assessment is that the economy
is still on track to post growth of 6.0% for this year and 6.8% in 2009 despite the
near term risks to growth.
The economy is still
on track to post 6%
growth this year
and 6.8% next
year
123

Economics: Singapore
Economics – Markets – Strategy
Singapore Economic Indicators
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
Real GDP (00P) 7.7 6.0 6.8 6.7 5.6 5.3 6.3 7.3 6.7
Private consumption 4.6 4.4 4.7 4.7 4.5 4.2 4.0 4.4 4.5
Government consumption 2.5 4.1 2.4 10.2 3.0 2.0 1.2 2.5 2.3
Gross fixed investment 20.6 23.7 11.7 30.0 25.0 22.1 17.8 12.8 11.0
Net exports (SGDbn) 66 59 63 11 15 19 14 13 15
Exports (% YoY) 6.6 6.6 7.3 9.2 6.1 5.0 6.0 7.3 7.3
Imports (% YoY) 6.8 8.8 7.3 13.8 8.0 7.3 6.3 6.3 7.5
Real supply
Goods producing industries 7.3 7.3 6.9 12.2 8.5 4.1 4.5 8.2 7.7
Manufacturing 5.9 6.3 6.5 12.4 7.5 2.5 2.7 6.9 7.0
Construction 20.3 16.4 12.1 14.7 19.7 16.0 15.5 17.9 15.6
Services 8.1 8.4 7.2 7.5 7.8 8.9 9.5 7.4 6.6
External (nominal)
Non-oil domestic exports 2.3 2.3 5.7 0.6 2.7 -0.7 6.8 8.0 5.3
Current account balance (USD bn) 41 45 52 n.a. n.a. n.a. n.a. n.a. n.a.
% of GDP 25 25 26 n.a. n.a. n.a. n.a. n.a. n.a.
Foreign reserves (USD bn) 163 179 203 n.a. n.a. n.a. n.a. n.a. n.a.
Inflation
CPI inflation 2.1 6.4 2.8 6.6 7.7 6.2 5.0 3.5 2.5
Other
Nominal GDP (USDbn) 162 181 199 n.a. n.a. n.a. n.a. n.a. n.a.
Unemployment rate (%, sa, eop) 2.0 2.0 1.7 2.0 2.3 2.4 2.0 2.1 1.9
- % change, year-on-year, unless otherwise specified
SG – nominal exchange rate
SGD per USD
1.58
1.55
1.52
1.49
1.46
1.43
1.40
1.37
1.34
6/11/2007 10/10/2007 2/8/2008 6/10/2008
SG – 3mth SIBOR
% pa
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
124

Economics – Markets – Strategy
Economics: Singapore
This page is intentionally left blank
125

Economics: Philippines
Economics – Markets – Strategy
PH: Back-tracking
• Things have turned topsy-turvy in the Philippines. Growth has been weaker
than expected and inflation is at a ten-year high
• First-quarter growth was low 5.2% YoY and 4Q07 growth was revised
downward to 6.4%. Although the revision made little difference to 2007
growth – fast 7.2% growth was recorded, the highest since 1981 – the pace
is now slowing. As surging inflation and higher interest rates take their
toll, growth this year should fall to 5.2% before recovering to 6% in 2009
• Inflation this year should average 9%, far above the central bank target of
3%-5%. We expect the BSP to continue lifting interest rates in 2H08, taking
the reverse repo (overnight borrowing) and repo (overnight lending) rates
75bps higher, to 6% and 8% respectively
• To cushion against slower growth, the government has deferred plans to
balance its budget this year. It is looking at spending up to PHP 1.26trn,
which it estimates will take the deficit to GDP ratio to 1%. We do not see
any risks to its projections; indeed chances are for an even slightly smaller
ratio of around 0.8%
PHILIPPINES
Following the 1Q07
GDP report, we
have cut our
growth forecast to
5.4% for 2008 and
6% for 2009
Growth slows
It is no exaggeration to say that first-quarter GDP growth was a shocker. We had
been expecting a slowdown from the blistering pace of growth in 2007, but not
that slow. The economy expanded just 5.2% YoY in 1Q08, versus our sub-consensus
forecast of 5.8%. Growth in 4Q07 was shaved a whole percentage point lower
from earlier estimates, to 6.4% YoY. Although the fourth-quarter revision was
“compensated” for by an upgrade to the 2Q07 numbers, which kept growth for
the full 2007 still robust at 7.2%, it still meant a very different growth profile
from the one we were looking
at three months back (Chart
1). Back then we would have
guessed a much more gradual
slowdown from 2007, to the
tune of 6.6% in 2008 and 6.7%
in 2009. Now, however, the
adjustment appears somewhat
sharper, and for this year and
the next we have revised our
growth forecasts lower, to 5.4%
and 6% respectively. The reasons
for the slowdown remain the
same as we have previously
laid out, with both domestic
and external demand set to
deteriorate, but now to a greater
degree than we initially
estimated (Chart 2).
Chart 1: Growth profile sharply lower
% YoY
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
Growth path
as at 1Q08
Growth path
as at 4Q07
7.4
6.4
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08
5.2
Lim Su Sian • (65) 6878 1740 • limsusian@dbs.com
126

Economics – Markets – Strategy
Economics: Philippines
Inflation to hit consumer spending
A key negative factor weighing
on the consumption outlook
in the coming quarters is inflation,
and this year we expect real
private consumption expenditure
(PCE) growth to slip to 5.4%,
before returning to 5.8% in
2009, the same pace as 2007.
As prices rise, the amount of
goods consumers can purchase
for the same amount of money
shrinks. This erosion of purchasing
power was already evident in
1Q08. Although we found the
slowdown in first quarter
consumption growth to be too
sharp and not quite
commensurate with the rise
Chart 2: Growth to slow this year
%-pt contrib to YoY GDP growth
20
15
10
5
0
-5
-10
DBSf 08: 5.4%,
09: 6.0%
Dec-06 Dec-07 Dec-08 Dec-09
PCE GCE Investment
Stat disc Net exports GDP YoY
in inflation, the negative correlation between prices and spending over time is
clear (Chart 3).
Chart 3: Inflation vs real spending
% YoY
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
CPI
inflation,
RHS (inv)
PCE growth
Latest: 1Q08
% YoY, inv
Mar-02 Mar-04 Mar-06 Mar-08
0
1
2
3
4
5
6
7
8
9
Chart 4: Headline inflation busts BSP's target
% YoY
12
10
8
6
4
2
0
BSP inflation
target
DBSf 08: 9%
Headline CPI
Latest: May08
Jan-03 Jul-04 Jan-06 Jul-07 Jan-09
We expect inflation to rise further in coming quarters on the back of food and
fuel prices. For the second quarter we only have April and May data in hand,
but headline inflation has already averaged a whopping 9% YoY. This compares
to an average of 5.5% YoY in 1Q08. Based on current trends, and on the observation
that prices generally face much greater resistance adjusting downwards than
upwards, our estimates suggest that headline inflation will surpass 10% YoY in
the remaining months of the year, peaking at above 11% YoY in Sept/Oct. Such
will take inflation for the year to 9%. More specifically, food inflation could rise
to above 16% YoY later this year. Given that food accounts for over 53% of
total consumer spending, this surge in prices must have an adverse impact on
PCE growth. Next year, as base-year effects wear off and assuming some stability
in energy prices, inflation should print 4.8% (Chart 4).
Prices have more
room to rise;
inflation this year
will average 9%,
and 4.8% in 2009
127

Economics: Philippines
Economics – Markets – Strategy
With its inflation
target shattered,
the central bank
will lift interest
rates by a further
75bps, taking the
repo rate to 7.25%
by end-08
Slower growth in
the US will weigh
on remittances;
peso weakness
helps only to a
degree
Business spending
will rise by a decent
7% this year, but
largely on public
spending
As will interest rate hikes
Still, our inflation forecasts are well above the BSP’s inflation targets for this
year and the next. This year the central bank’s inflation target is at 3-5%, and
next year inflation is targeted at 2.5-4.5%. In view of this, we expect the central
bank to continue the tightening cycle it embarked on earlier this month. The
overnight reverse repo (borrowing) and repo (lending) rates were lifted 25bps
to 5.25% and 7.25% respectively, and we expect a further 75bps of tightening
before the year is up, to be delivered in three moderate steps of 25bp each.
These interest rate hikes should help to contain risks of a wage-price spiral by
dampening activity. Under pressure from the unions to mitigate the impact of
higher food and fuel prices on workers, the government in mid-May mandated
a nation-wide increase in private-sector minimum wages, to be rolled out in the
different regions over the next few months. Some areas (like metro Manila) will
see moderate hikes of around 5%, but increments in some provinces will come
to around 10%. Some of these wage increments will also come on top of previous
wage orders still currently being implemented. As part of a longer-standing
plan, public sector workers are also set to receive a 10% pay rise on July 1.
Admittedly, even after lifting rates by a further 75bps, monetary policy can still
be described as “loose”; after adjusting interest rates for inflation, they are
negative. In other words, the value of money sitting in a consumer’s bank deposit
actually decays, and there is greater incentive for him to take it out to spend or
invest. But free spending would occur only if consumers had no concerns over
economic and labour market prospects.
Clearly this will not be the Chart 5: Remittances and real US GDP growth
case in the coming quarters.
We continue to expect the US
% YoY % YoY, 3mma
to fall short of longer-term 4.5
30
potential growth both this year
Remittances
4.0
and the next, having pencilled
(RHS)
US GDP
25
3.5
in growth of 2.0% and 2.6%
respectively; potential growth 3.0
20
is widely thought to be between 2.5
2.75-3.25%. Given that the US
15
2.0
accounts for 53% of the
Philippines’ remitted earnings 1.5
10
and 17% of the export market, 1.0
this will have a negative bearing
5
on domestic wage and spending
0.5
patterns (Chart 5). Further 0.0
0
weakness in the peso this year Mar-02 Mar-04 Mar-06 Mar-08
will help soften the blow on
both remitted earnings and
exports – we expect USD/PHP to end the year at 47.00 – but not sufficiently.
Investment to remain robust on public spending
Investment spending was the only component in the first quarter GDP figures
that did not disappoint us, and while we believe last year’s 11.8% surge in
capital outlays will not be replicated, investment this year should still rise a
decent 7.0%. However, this is likely to ride on public, rather than private outlays.
As input costs like oil and commodities continue to rise and it becomes increasingly
difficult to pass on higher costs to consumers, private firms will feel greater
margin pressure. In such an environment, business spending plans will naturally
be deferred. Indeed, private-sector investment indicators so far this year have
been very weak. According to the BSP’s second-quarter Business Expectations
128

Economics – Markets – Strategy
Economics: Philippines
Survey, only a net 12.6% of firms were optimistic over conditions in the current
quarter, a 17.3pt plunge from the 1Q08 reading and the lowest in three years.
For the quarter ahead – or 3Q08 - only a net 16.6% were optimistic, a 24.4pt
drop from the previous reading (Chart 6).
The unwillingness of the private sector to spend will contrast sharply against
ongoing public spending on infrastructure. Plans to balance the budget this
year have been pushed aside (possibly till as late as 2010, judging by official
comments), and this year’s PHP 1.23trn budget now looks set to be upped to PHP
1.255trn. This is a sum that includes a PHP 18.6bn windfall from the 12% VAT on
petroleum products. Details of the new budget have not yet been released, but
under the previous spending plan, some PHP 113bn – or 9.2% of the budget –
was to have been spent on infrastructure items such roads, bridges, airports and
sea ports.
The private sector
will hold back
spending, but the
government is
planning fiscal
stimulus
Chart 6: Business expectations plunge
Business Outlook index
60
50
40
Chart 7: Balanced budget goal out the window
% of GDP
1
0
-1
30
-2
20
10
0
Current qtr
Next qtr
-3
-4
Govt
forecast
-10
Latest: 1Q08
-5
-20
Dec-04 Dec-05 Dec-06 Dec-07
-6
1997 1999 2001 2003 2005 2007
According to Finance Secretary Teves, the increased spending will take the budget
deficit to at most PHP 75bn, or 1% of GDP (Chart 7). This implies revenues of at
least PHP 1.18trn will be needed. Based on our growth assumptions, this should
be achievable, with some room for expenditure to even slightly exceed current
plans.
External outlook still rough
As with consumption, the
country’s external trade
performance this past quarter
has been disappointing, and
we now look for net exports
to subtract a hefty 1.6%-pts
from the overall growth
headline. Real exports in the
first quarter contracted 11.1%
YoY, the first decline in six
years. Imports, reflecting export
trends and weaker domestic
demand, also declined, by
6.6%. As is evident from Chart
8, the drop in exports occurred
on a combination of weak
external demand particularly
Chart 8: Exports feeling the pain on all fronts
% YoY, 3mma Ratio
25
USD terms 1.3
20
PHP terms
1.2
15
10
1.1
5
0
-5
-10
-15
-20
US Semicon BB
ratio (RHS)
Latest: Exports Mar08,
BB ratio Apr08
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
1.0
0.9
0.8
0.7
0.6
Net exports will
subtract 1.6%-pts
from growth this
year
129

Economics: Philippines
Economics – Markets – Strategy
Demand from US,
Asia to weaken
further
for electronics, and a much stronger peso. In the quarters ahead, exports should
find some reprieve from the 9% or so depreciation we expect in the peso – as
mentioned earlier, we expect USD/PHP to rise to 47.00 by the year-end.
But clearly the Philippines’ export growth is underperforming Asia, suggesting
a lack of competitiveness; for example, countries such as Thailand saw real export
growth of 8.7% YoY in 1Q08. Adding to this, global growth is set to slow further
this year. We expect growth in the Asia 10 economies (including China and
India) to slow to 6.1% on average, from 7.0% last year. US and Japan should
average 1.9%, from 2.1%. Combined, these economies make up almost 80% of
Philippines exports. Further slippage in shipments therefore looks likely. We
have revised our real export forecast downwards to factor in a 7.9% drop, while
imports should decline 5.1%.
130

Economics – Markets – Strategy
Economics: Philippines
Philippines Economic Indicators
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
Real GDP growth 7.2 5.4 6.0 5.2 5.4 5.2 5.7 5.7 5.5
Private consumption 5.8 5.4 5.8 5.1 5.8 5.4 5.4 6.2 5.6
Government consumption 8.3 9.9 4.5 -1.0 15.0 13.5 11.2 5.0 1.0
Gross fixed capital formation 11.8 7.0 5.4 6.6 8.0 7.0 6.5 5.0 3.0
Net exports (PHP bn, 85P) 51.0 29.3 34.6 0.9 10.4 24.8 -6.8 2.4 11.9
Exports 5.6 -7.9 12.1 -11.1 -13.5 -8.0 2.0 8.0 15.0
Imports -4.5 -5.1 11.8 -6.6 -9.0 -6.0 1.0 7.0 15.0
External (nominal)
Merch exports (USD bn) 50.5 49.4 52.7 12.5 11.4 12.1 13.4 13.3 12.2
- % YoY 6.4 -2.1 6.6 2.8 -8.2 -5.3 2.4 6.2 7.5
Merch imports (USD bn) 55.5 65.7 71.3 14.6 16.0 17.5 17.6 16.1 17.2
- % YoY 7.2 18.3 8.5 20.1 20.2 18.4 15.2 10.4 7.2
Merch trade balance (USD bn) -5.0 -16.3 -18.6 -2.1 -4.7 -5.4 -4.1 -2.8 -5.0
Current account balance (USD bn) 6.4 4.8 6.4 5.8 5.1 5.2 4.8 5.0 5.6
% of GDP 4.3 2.8 3.3 n.a. n.a. n.a. n.a. n.a. n.a.
Foreign reserves, USD bn 34 37 48 37 36 36 37 41 45
Inflation
CPI inflation 2.8 9.0 4.8 5.5 9.3 10.7 10.6 8.9 5.2
Other
Nominal GDP (USD bn) 148 169 192 n.a. n.a. n.a. n.a. n.a. n.a.
Budget deficit (% of GDP) -0.9 -1.0 -0.5 n.a. n.a. n.a. n.a. n.a. n.a.
Total external debt (USD bn) 52 51 50 n.a. n.a. n.a. n.a. n.a. n.a.
% of GDP 35 30 26 n.a. n.a. n.a. n.a. n.a. n.a.
* % change, year-on-year, unless otherwise specified
PH – nominal exchange rate
PHP per USD
48
46
44
42
PH – policy rate
%, o/n rev repo
14.0
12.0
10.0
8.0
6.0
40
6/11/2007 10/10/2007 2/8/2008 6/10/2008
4.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
131

VIETNAM
Economics: Vietnam
Economics – Markets – Strategy
VN: Growing pains
• Inflation has reached a crisis stage and strong measures are needed to cool
the economy
• The State Bank of Vietnam (SBV) raised interest rates sharply again on 10
Jun08, less than a month after the previous hike, in a bid to tame inflation.
• Yet, despite the measures by the government to rein in inflation, it is unlikely
to abate in the near term and is set to average about 26.3% for the full year
• Vietnam’s widening trade deficit is another concern. The trade deficit has
ballooned to 53% of GDP in 1Q08 on an unadjusted basis
• With fiscal and monetary tightening, and the negative impact of high
inflation, growth this year will be sub-par at 6.4%
CPI inflation surged
to 25.2% YoY in
May08
Inflation worries
Inflation worry in Vietnam has taken a new dimension in recent days. CPI inflation
surged to 25.2% YoY in May08 , as food prices continue to drive the headline
number upwards (Chart 1). Overall food and foodstuffs prices were up 42.4%
compared to a year ago while prices of primary food items were up a shocking
67.8% YoY! The situation is worrisome as food items take up about 40% of the
overall CPI basket and prices are unlikely to stabilize in the near term. The rice
crisis spreading across Asia and much of the world threatens to keep prices
elevated. Global supply is unlikely to catch up with demand from both speculative
and real sources in the short-term and with that, grain prices are expected to
stay high in the near term. Earlier on, the Vietnamese government has taken
measures to curb domestic speculation in addition to tighter export controls on
rice. However, food inflation is also increasingly spreading into prices of other
non food items.
Apart from commodity prices, the inflation problem in Vietnam is also partly
due to excessive liquidity. Money supply growth registered about 46% increase
by end 2007 according to the Asian Development Bank (Chart 2). Sharp increase
Chart 1: High inflation is a key concern
% YoY
45
42.4%
40
35
Overall CPI inflation
Food
25.5%
30
CPI inflation ex food
25
20 Latest: May08
15
10
5
0
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
Chart 2: Excessive liquidity also stoking inflation
VND bn
% YoY
1600000
50
Money supply, M2
1400000
45
M2 growth (RHS)
40
1200000
35
1000000
30
800000
25
600000
20
15
400000
10
200000
5
0
0
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04
Irvin Seah • (65) 6878 6727 • irvinseah@dbs.com
132

Economics – Markets – Strategy
Economics: Vietnam
in FDI inflows, remittances and portfolio investment betting on the property
and equity market boom in 2007 are probably the key reasons. The banking
sector is flooded with cash and the aggressive credit extension by commercial
banks to earn market share probably exacerbated the situation.
Indeed, the inflation problem in Vietnam has reached a crisis stage and drastic
counter-measures are needed to bring an overheated economy into order. After
some drastic tightening move on 19 May, the State Bank of Vietnam (SBV) again
raised all three policy rates by 200bps on 10 June in a desperate bid to tame
inflation. That’s two series of sharp rate hikes within a month. The prime/base
rate was raised to 14%. The discount rate and refinance rate were lifted to 13%
and 15% respectively. Yet, the drastic and painful monetary tightening was
needed to contain the excess liquidity in the system and to ensure banks have
the mechanism available to mobilize deposits if necessary.
Apart from monetary measures, the government has also adopted administrative
measures to tame inflation. For example, the government froze prices of 10
“essential” goods until June. They include petrol, electricity, coal, water, cement,
steel, school fees and hospital fees, bus, rail and air travel. The government also
promised to cut fiscal expenses by 10% through belt tightening. That is essentially
a contractionary yet necessary fiscal policy which will surely affect overall growth
outlook as many public infrastructure projects will be postponed as a result.
More tightening needed
Despite the desperate
measures by the government
to rein in inflation, it is unlikely
to abate in the near term.
In fact, our estimation based
on the current global trend
for crude oil and food prices
point to even higher inflation
ahead. Moreover, effects of
the monetary tightening will
take time to filter through
the system while the declining
VND is complicating matters.
Full year inflation in Vietnam
is estimated to average 26.3%
and will easily breach the
30% level once some of the
existing subsidies are lifted
Chart 3: More tightening needed to tame inflation
% YoY, % pa
DBSf
40
30
20
10
0
-10
-20
-30
Real prime rate
Inflation
Prime rate
Jan-07 Jul-07 Jan-08 Jul-08
(Chart 3). However, inflation in 2009 should taper off to 15% on average as
growth moderates and the tightening measures start to take effect.
Nonetheless, more tightening may be needed in the near term to keep the lid
on inflation. In fact, the real base rate (inflation adjusted) is expected to remain
in negative territory in the near term until mid 2009, which will gives more
room for rate hikes (Chart 3). The government has demonstrated its will to fight
inflation in its recent tightening moves. With that, we expect the base rate to
be lifted by another 200bps in the next 2 quarters to 16% to help clamp down
inflation.
Inflation has
reached the crisis
stage and strong
counter-measures
are needed
Despite tightening,
inflation will hit
26.3% for the year
Expect another
200bps hike in base
rate
Widening trade deficit is another big concern
Apart from inflation, Vietnam’s widening trade deficit is another big concern.
Trade deficit registered USD 14.4bn in May year-to-date, about four times higher
than a year ago and already surpassed the deficit for the entire 2007 (Chart 4).
Trade deficit exploded from about 18% of nominal GDP for the whole of 2007
133

Economics: Vietnam
Economics – Markets – Strategy
to about 53% (seasonally unadjusted) for just the first quarter of this year. The
27.5% rise in exports was dwarfed by a staggering 70.5% increase in imports.
High oil prices is also aggravating the problem. With oil prices well above USD130/
bbl, the value of crude export rose 46%, but a near doubling in imports of
refined products turned a USD 976mn oil surplus in 2007 to a USD 334mn deficit
Chart 4: Trade deficit exploded
% of nom. GDP, nsa
10
0
-10
-20
-30
-40
-50
0.7
-7.0 -7.9 -7.9
Trade bal / Nom. GDP
Chart 5: Oil balance turned negative
USD mn
1200
1000
800 Oil trade balance
600
400
200
0
-200
-13.0 -15.2 -16.2 -17.5
-52.6
-60
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08
-400
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08
The oil balance
turned negative on
the back of high oil
prices
The trade deficit
ballooned to 53%
of GDP in 1Q08
now (Chart 5). Vietnam is a crude oil exporter but imported large quantity of
refined petroleum for domestic consumption. The ballooning oil deficit is not
only causing pain on the trade account but also feeding into inflation. But its
not all about oil. Petroleum imports formed only about 13% of total imports as
of May08. Huge increases were also seen in many other import products, reflecting
the strong domestic investment demand.
With the ongoing trend in Chart 6: Trade & current acc. have deteriorated
both exports and imports,
% of nom. GDP
trade deficit could well register
10
a massive USD 24bn this year
even if we assume an 5
improvement in the trade 0
balance given a weaker
currency (Chart 7). That is
-5
about twice the amount -10
recorded in 2007 and about
-15
29.3% of overall nominal GDP
this year! The current account -20
Current account balance
will likely be dragged down -25
Trade balance
as well. The current account
-30
balance already registered
a shortfall of USD 6.7bn in -35
2007 (based on IMF estimates), 1998 2000 2002 2004 2006 2008f
about 9.4% of nominal GDP
and will likely fall further given the recent trend in the trade account. With the
likelihood of sharp current account outflow, there is risk of a balance of payment
(BOP) shortfall if further deterioration in Vietnam macro stability triggers a reversal
in capital flows. However, with a competitive labour force, large pool of natural
resources and appropriate measures from the government, Vietnam is expected
to remain attractive to foreign investors in the medium term. We believe that a
134

Economics – Markets – Strategy
Economics: Vietnam
steady inflow of FDI plus an improving services trade account will provide the
counter-balance to the deficit position in the merchandise trade account.
In addition, there is substantial ground to believe that a weaker VND could help
to alleviate the trade account problem. Yet, we do not expect the SBV to deviate
substantially from the current downward crawling peg against the USD. The
pace of depreciation may accelerate in an attempt to close the gap in the current
account but a collapse in the currency is unlikely given Vietnam’s positive long
term growth outlook. However, a weaker currency may invite higher imported
inflation and, therefore, it is probably not the most preferred policy instrument
for the problem in Vietnam right now. We believe the government will instead
place its bet on domestic monetary tightening, administrative and other controls
on credit as well as fiscal contraction to engineer a soft landing for the economy.
Tough action needed to rectify previous policy flaws
The inflation problem in Vietnam has revealed the underlying policy inconsistency
in the system. The government’s loose monetary and fiscal policy framework
complicated by the sharp rise in foreign capital inflows last year are probably
the main reasons for the recent spate of inflation. The inflationary impact of
these capital inflows has been exacerbated by the inability to fully sterilize the
inflows due to its undeveloped capital markets. Couple that with the deteriorating
current account, partly the result of “excessive” domestic demand, Vietnam is
at the crossroads as far as policy is concerned. The government needs to act
swiftly and decisively in its tightening measures to prevent runaway inflation
and a fallout in the balance of payment account. The recent tightening move
by the central bank is certainly the right way forward but more needs to be
done to rectify the problem. Hence, we expect further monetary as well as fiscal
tightening by the government going forward.
Growth is likely to under-perform
With the concurrent fiscal and Chart 7: GDP growth will moderate
monetary tightening, negative
% YoY
impact of high inflation on
domestic consumption, weak 9.0
Real GDP growth
investment and consumer 8.5
DBSf
sentiment on the back of spikes
in interest rates, growth will surely 8.0
undershoot. Growth in the first 7.5
quarter registered 7.5% which
led to the downgrade in the official 7.0
growth target to 7.0%, down 6.5
from 8% earlier on. We reckon
that against the backdrop of rapidly 6.0
Latest: 1Q08
deteriorating fundamentals,
5.5
growth for the full year could
end up worse than expected at 5.0
6.4% before improving to 6.9% Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09
in 2009 when confidence in the
economy returns (Chart 8). Indeed, near term downside risks to growth remain
extremely high and there could be many pitfalls along the way. Bitter and painful
restructuring will be necessary to prevent similar economic crisis from happening
in future.
A weaker VND
could help to
alleviate the trade
deficit
The government
must act decisively
in its tightening
measures
Growth for the full
year should
register 6.4%
135

Economics: Vietnam
Economics – Markets – Strategy
Vietnam Economic Indicators
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
GDP growth 8.5 6.4 6.9 7.5 6.0 5.8 6.4 6.5 6.4
Real supply
Agriculture & forestry 3.4 3.4 3.4 3.2 3.2 3.4 3.8 3.7 3.2
Industry & construction 10.6 6.6 7.4 8.0 6.1 5.9 6.4 6.4 6.6
Services 8.7 7.5 7.8 8.3 7.6 6.6 7.6 7.5 8.0
External (nominal)
Exports (USD bn) 48.4 63.1 85.5 13.2 15.7 16.2 18.1 17.7 21.2
Imports (USD bn) 60.8 87.6 98.6 21.5 23.8 20.7 21.5 24.9 27.0
Trade balance (USD bn) -12.4 -24.4 -13.1 -8.3 -8.2 -4.5 -3.4 -7.2 -5.8
Current account bal (USD bn) -6.7 -11.7 -5.7 n.a. n.a. n.a. n.a. n.a. n.a.
% of GDP -9 -14 -6 n.a. n.a. n.a. n.a. n.a. n.a.
(USD bn, yr-end)
Inflation
CPI inflation 8.3 26.3 15.0 16.4 24.8 31.5 32.3 25.1 16.6
Other
Nominal GDP (USDbn) 71.4 82 92.5 n.a. n.a. n.a. n.a. n.a. n.a.
Unemployment rate (%, sa, eop) 3.8 3.7 4.2 n.a. n.a. n.a. n.a. n.a. n.a.
- % change, year-on-year, unless otherwise specified
- Figures may deviate from official sources due to difference in reporting format
VN – nominal exchange rate
VND per USD
16400
16280
16160
16040
15920
15800
01/01/200705/11/200709/20/200701/30/200806/10/2008
VN – prime interest rate
% pa
15.0
14.0
13.0
12.0
11.0
10.0
9.0
8.0
7.0
6.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
136

Economics – Markets – Strategy
Economics: Vietnam
This page is intentionally left blank
137

UNITED STATES
Economics: United States
Economics – Markets – Strategy
US: Forecasts rising
• The US will handily avoid recession this year
• “Consensus” growth forecasts are rapidly heading northward
• But the US came closer to recession than we imagined and remains weak.
Domestic demand growth has been zero for two full quarters
• US growth is being kept alive by foreign demand. It has accounted for
100% of US growth for the past two quarters and 46% over the past
year. That is 2-3 times what foreign demand ever contributed to China’s
growth
• Domestic demand will be stronger in Q2 and especially in Q3 and Q4
• Oil prices are a burden but it is being paid in real time. Oil is not a
hammer waiting to fall on growth
• The Fed will hike rates by 50bps in 4Q08, by another 75bps in 1Q09 and
another 75bps in 2Q09. That would put Fed funds at 4% by Jun09
Forecasts are going up
Recession is not on
the cards. But
domestic demand is
nowhere to be
seen
Notwithstanding all the hoopla back in January and February, the US will handily
avoid recession this year. First quarter GDP grew by 0.9% (QoQ, saar) and consensus
forecasts for second quarter growth are rapidly heading northward. Consensus
now expects the same 1.5% growth in the second quarter that we do. With
continued (and importantly, non-cyclical) core consumption growth, fiscal injections
worth 1.4% of GDP coming on stream and the best global balance in 20 years,
growth should rise further in Q3 and Q4. We expect GDP to expand by 2.5%
and 2.75%, respectively, implying full year average growth of 2% in 2008. That’s
a tad shy of last year’s growth (2.2%), a tad lower than last quarter’s ‘08 forecast
(2.1%) and a country mile away from recession.
US - GDP and domestic demand growth
%YoY, 2qma
4.5
4.0
3.5
3.0
2.5
2.0
GDP
(total demand)
Dom Demand
2.5%
GDP:
1.6 ppts
DD:
2.7 ppts
1.5
1.0
1.5%
1.7%
Sep-
03
Mar-
04
Sep-
04
Mar-
05
Sep-
05
Mar-
06
Sep-
06
Mar-
07
Sep-
07
Mar-
08
David Carbon • (65) 6878 9548 • davidcarbon@dbs.com
138

Economics – Markets – Strategy
Economics: United States
Is everything fine in America? Decidedly not.
In fact, the US came a lot closer to recession
than we expected and risks for such remain.
GDP growth remains positive but American demand
– the sum of consumption, investment and
government spending – has not grown one iota
for two quarters.
How does GDP grow when domestic demand
does not? Who is buying the incremental output?
Foreigners. Net purchases by foreigners of US
goods have delivered every penny of US growth
since 3Q07. That contribution has risen but it’s
not new. Over the past year, foreigners have
US – foreign contribution to GDP growth Mar07-Mar08
USDbn/qtr, saar, 00P
Contribution
(1) (2) (2)-(1) to GDP chg
Mar-07 Mar-08 Change (%)
GDP 11,413 11,702 289
Net exports -612 -480 132 46
Exports 1,355 1,474 119 41
Imports 1,967 1,954 -13 -4
Dom Demand* 12,025 12,182 157 54
* GDP less net exports
bought 46% of the increase in US GDP. That’s 2-3 times what foreign demand
ever contributed to China’s growth and the US used to do a lot of complaining
about China living off the rest of the world. Good thing the stone throwing has
eased of late because the US house is looking pretty glassy at the moment.
Growth in the second quarter will remain fragile but a bigger portion of it
should come from domestic demand. Consumption should again grow by about
1% (QoQ, saar) and, because it accounts for about 70% of GDP, should (again)
deliver about .7 points of headline growth. Investment should make a decent
contribution in Q2 compared to the empty plate it was in Q1. Durable goods
orders and shipments point to capex growth of 4%-5%.
Housing construction continues to fall. It, and new home sales, have been
dropping at a 25% annualized pace for 2.5 years now and neither show no any
sign of abating yet. The good news is, the cost of the construction drop is
known and relatively small. It has been knocking off about 1 percentage point
from GDP growth every quarter for 2.5 years, turning 3% growth into 2%, or
2% into 1%, and so on. That’s a drag but it’s not deadly. We continue to expect
it to fade considerably in 2H08 but such an outcome is not crucial to the forecast.
Besides foreign demand, what has kept the US clock ticking (and will continue
to) is consumption, core consumption mainly. This may sound funny because
what has had the worriers worried for the past few years is not the housing
sector per se, but that weakness there would spill over into consumption. Our
view on consumption and on the risk it poses for recession is pretty much flipped
around from this. In our view, consumption – especially core consumption, the
US - real consumption of services
US$bn, 2000p, seas adj.
4800
4700
Consumption
prevents /
attenuates a
recession. It
doesn’t cause one
4600
4500
4400
4300
4200
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
139

Economics: United States
Economics – Markets – Strategy
Higher oil prices are
a burden but it is
paid for in real
time. Oil prices are
not a hammer
waiting to fall on
future growth
everyday nuts and bolts of total expenditure, most of which has to be spent in
good times and bad – is what attenuates, or drags an economy out of recession
when it has fallen into one for some other reason. It is not what pulls an
economy into recession.
The solid straight line of services consumption growth shown in the picture on
the previous page is a good indication of what we’re talking about. Investment
may fall, jobs may fall and, eventually, total consumption may fall. But core
consumption, 60% of GDP, grinds forward. It’s not fast, it’s not sexy but it is big
and reliable and for these reasons it tends to keep growth on track.
Oil
Total consumption is certainly facing some headwinds of late but that has more
to do oil prices and the price of gasoline than anything else. Oil prices have
tripled since January 2005 and vehicle sales have been falling since July of the
same year. The surge in crude (50%) and pump (35%) prices since January has
thrown even more cold water on sales.
Higher oil prices are a burden but they appear compellingly to have been driven
by strong global demand and income growth over the past 5-6 years (see Economic
Overview, “On a clear day”, above). On this time frame, oil prices have grown
fivefold. Growth in most parts of the world ‘survived’ the high oil prices because
it drove the high oil prices.
In this light, US growth faces headwinds from oil prices no greater or less than
it has faced for the past five years. Further rises in oil prices would have further
impacts on things like vehicle sales but it would not lower GDP growth later this
year any more than it already has over the past five years.
To be sure, US growth is not sterling at the moment. And foreign growth is
driving oil prices more than growth in the US, Japan or Europe, where oil consumption
has fallen for the past three years if not the past 12 (see “On a clear day”). Is the
US suffering weak growth because foreigners are pushing up the price of oil?
No. US growth is weak because of the US subprime crisis and the collapse in the
housing market. Foreign demand, as we discussed earlier, is the only thing
keeping US growth alive right now. So if foreigners are pushing up the price of
oil, that is the price of their keeping US growth afloat at the same time.
Global growth
‘survived’ higher oil
prices because it
drove higher oil
prices
US - core inflation
% YoY, core PCE and core CPI
3.0
core CPI
2.8
2.6
2.4
2.2
2.0
Actuals thru April
1.8
core PCE
1.6 Sep06
Aug07
Apr08 Aug08
1.4
Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09
140

Economics – Markets – Strategy
Economics: United States
United States Economic Indicators
2007 --- 2008 --- -- 2009 --
2007 2008(f) 2009(f) Q4 Q1 Q2 (f) Q3 (f) Q4 (f) Q1 (f) Q2 (f)
Output & Demand
Real GDP* 2.2 2.0 2.6 0.6 0.9 1.6 2.5 2.7 2.8 2.8
Private consumption 2.9 1.7 2.1 2.3 1.0 1.0 2.0 2.2 2.2 2.2
Business investment 4.7 4.8 5.9 6.0 -0.3 3.5 7.0 7.0 5.0 6.0
Residential construction -17.0 -20.1 -2.7 -25.2 -25.5 -20.0 -10.0 -5.0 1.0 2.0
Government spending 2.0 2.4 2.3 1.9 2.0 2.3 2.3 2.3 2.3 2.3
Exports (G&S) 8.1 6.4 5.6 6.5 2.8 5.5 4.7 3.3 6.6 6.5
Imports (G&S) 1.9 0.3 4.0 -1.4 -2.6 2.0 2.5 2.5 5.0 5.0
Net exports ($bn, 00P, ar) -556 -470 -465 -503 -480 -470 -465 -465 -465 -465
Stocks (chg, $bn, 00P, ar) 5 -4 5 -18 -14 0 0 0 5 5
Contribution to GDP (pct pts)
Domestic final sales (C+FI+G) 2.1 1.4 2.5 1.5 0.0 0.8 2.3 2.7 2.6 2.8
Net exports 0.6 0.7 0.0 1.0 0.8 0.3 0.2 0.0 0.0 0.0
Inventories -0.3 -0.1 0.1 -1.7 0.1 0.5 0.0 0.0 0.2 0.0
Inflation
GDP deflator (% YoY, pd avg) 2.0 1.9 2.3
CPI (% YoY, pd avg) 2.9 3.8 2.6 4.0 4.2 3.9 3.9 3.4 3.0 2.5
CPI core (% YoY, pd avg) 2.3 2.5 2.3 2.3 2.4 2.6 2.5 2.5 2.3 2.3
PCE core (% YoY, pd avg) 2.1 2.4 2.1 2.1 2.0 2.4 2.5 2.4 2.2 2.2
External accounts
Current acct balance ($bn) -739 -734 -785
Current account (% of GDP) -5.3 -5.1 -5.2
Other
Nominal GDP (US$ trn) 13.8 14.4 15.1
Federal budget bal (% of GDP) -0.9 -1.5 -2.5
Nonfarm payroll** 115 -2 126 80 -82 -35 25 85 120 125
Unemployment rate (%, pd avg) 4.6 5.2 5.1 4.8 4.9 5.3 5.3 5.2 5.2 5.2
* % period on period at seas adj annualized rate, unless otherwise specified
** Change, x1000, month avg
Fed
We revised our Fed forecast in mid-May, bringing forward our expectations for
the first round of Fed hikes to 4Q08 from 1Q09. We look for 50bps of hikes
then, mainly on the view that growth will be running between 2.5% and 2.75%.
Interest rates simply do not belong at 2.00% with growth of this sort, especially
in an environment of relatively high and perhaps still rising inflation at yearend.
Oil prices, currently at USD135/bbl (Brent & WTIC), will continue to drive headline
and core inflation higher through the summer months. We expect core CPI and
PCE inflation to rise to 2.6% YoY by August – well outside the Fed’s comfort
zone of 1% to 2% – and, if oil prices continue to rise, inflation would not stop
there as we currently anticipate.
In the event, we look for another 75bps of Fed hikes in each of 1Q09 and 2Q09.
That would leave Fed funds at 4.00% by July09. With neutral Fed funds at
about 4.75%, the expectation must be for further hikes in 3Q09.
We expect 50bps of
hikes in 4Q08,
followed by 75bps
of hikes in each of
1Q09 and 2Q09.
That would put Fed
funds at 4.00% by
Jul09
Sources:
Sources for all charts and tables are CEIC and Bloomberg .
141

Economics: Japan
Economics – Markets – Strategy
JP: What virtuous cycle?
• In the past three months, the markets have swung from worrying about a
recession to factoring in a rate hike by the BOJ by the year-end. Neither
scenario will materialize
• There will be no recession but growth will fall to 1.6% in 2008 from 2% in
2007
• This year, the 1.0% (QoQ, sa) expansion recorded in 1Q08 will be as good
as it gets. The central bank’s “virtuous cycle” between exports, production,
profits and business and household spending has gained no traction. The
gradual decay in export growth since early 2006 has become more
pronounced, owing to cooler demand from Asia and the US. Corporate
margins are being squeezed by higher fuel and commodity prices.
Households have little prospect of seeing wage growth emerge from longterm
stagnation; as inflation rises, the likelihood is for consumers to tighten
their belts
• In this context, the Bank of Japan (BOJ) has no room to lift the overnight
call target rate of 0.50% this year. Rising inflationary expectations, however,
raise the odds that the central bank could seize the opportunity to lift
interest rates if economic data improves. This could come as early as 1Q09;
although we have ‘downgraded’ the annual average YoY growth rate to
1.6% for 2009, in QoQ terms growth should actually average a relatively
stronger 0.7%, versus a 0.3% QoQ average this year
JAPAN
The global
electronics cycle
remains in a slump
Exports will keep slowing…
In 1Q08, exports rose by a surprisingly strong (seasonally adjusted) 4% QoQ,
despite the yen having appreciated by about the same degree in real tradeweighted
terms. In the next six months, we expect the yen to give back some of
those gains, with our forecast being for USD/JPY to finish the year at 107.00. But
this will mean little for the export growth outlook, in the face of what will be
continued weakness in the global
electronics cycle. The hopeful
pick-up in the US semiconductor
equipment book-to-bill ratio
in 4Q07 has all but dissipated,
and as at Apr08 the ratio is
almost back down to where
it was six months ago - a subparity
0.81. Given that the bookto-bill
ratio tends to lead Japan’s
export cycle by about three
to six months, shipments are
likely to remain soft for the
remainder of the year (Chart
1).
Further putting the brakes on
export growth will be the
slowdown in global growth
-10
-15
Lim Su Sian • (65) 6878 1740 • limsusian@dbs.com
Chart 1: Electronics cycle still in the doldrums
% YoY Ratio
25
20
15
10
5
0
-5
US semi BB ratio
(RHS)
Merch exports
Latest: Apr08
Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
142

Economics – Markets – Strategy
Economics: Japan
this year, particularly in Asia,
which now buys close to half
Japan’s exports. This year we expect
growth in the Asia 10 economies
(including China and India) to
slow to 6.1% on average, from
7.0% last year. The US, while
skirting a recession, will also see
sub-par growth of 2.0%; this market
accounts for around 18% of Japan’s
exports. So, even as demand from
markets like Central and Eastern
Europe continues to barrel on
at over 40% YoY every month,
cooler economic growth in Japan’s
key markets will still result in
declining shipments, as has been
the case for the past several months
(Chart 2).
In quarter-on-quarter terms, this means markedly slower export growth of 2.3%
QoQ on average for the next three quarters. In YoY terms, however, export
growth for the full year will look a (misleadingly) strong 12.2%, from 8.6% in
2007. Sequentially, import growth will also be moderate at 1.8-2% QoQ, though
in annual average YoY terms this translates to a 6.0% rise. Net of imports, exports
should contribute 1.2%-pts to overall GDP growth for the year.
… further hurting corporate earnings
Chart 2: Export contributions from Asia, US falling
%-pt contrib to export growth
20
15
10
5
0
-5
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08
Asia
C&E Europe, Russia
Rest of world
Latest: Apr08
N. America
Mid-East
Exports, % YoY
The soft conditions facing exporters, which account for some 20% of the economy,
will not help overall corporate earnings, which are already under significant
strain owing to the surge in cost of inputs like oil and commodities. According
to the MOF’s first-quarter corporate survey, revenues fell 1.5% YoY during the
quarter, largely reflecting a contraction in revenues among non-manufacturers.
More notably, operating profits were down 14.2% YoY across all industries, the
biggest decline in six years (Chart 3). According to our estimates, profit margins
peaked in the second to third quarter of 2007, and are currently undergoing a
relatively sharp correction in both the manufacturing and non-manufacturing
sectors (Chart 4).
These poor business conditions explain why we saw business spending growth
of just 0.2% QoQ in 1Q08. Indeed, for the remainder of the year we believe
Demand from Asia,
US is weakening
Export growth to
slow
Cooling external
demand and higher
input costs are
hurting corporate
profits
Chart 3: Sales, profits contracting
% YoY
40
30
20
10
0
-10
-20
-30
-40
Operating
profits
Sales
Latest: 1Q08
Jun-97 Jun-99 Jun-01 Jun-03 Jun-05 Jun-07
Chart 4: Profit margins rapidly thinning
Profit to sales ratio, sa
6
5
4
3
2
1
0
Latest: 1Q08
All indust
Manuf
Non-manuf
Jun-97 Jun-99 Jun-01 Jun-03 Jun-05 Jun-07
143

Economics: Japan
Economics – Markets – Strategy
Business outlays
will fall 1.4% this
year
business spending will actually contract, in both sequential and year-on-year
terms. For the full year, private non-residential investment should fall 1.4%,
compared to a 1.9% gain in 2007. Even after factoring in a sharp (technical)
recovery in residential investment, total private investment will still be down
1.1% on the year.
No chance of wage growth
With profit earnings and margins under pressure, it is hard to see wage growth
emerging from its long-term stagnation any time soon. Since Dec07 cash earnings
have rebounded slightly (to a negligible 1% YoY as of Apr08), but as evident
from Chart 5, earnings for the past few years have spent much more time declining
than rising. Indeed, since the Asian crisis of 1997, earnings have in fact contracted
0.7% YoY on average, in part reflecting the shift by employers towards (cheaper)
part-time workers.
The job market is
weakening
The stagnation in wage growth occurred in spite of a significant recovery in the
labour market, particularly between 2003 and 2007; the rate of unemployment
fell nearly to pre-crisis levels, and there were significantly more jobs per applicant
than before the crisis. Since end-2007, however, labour market conditions have
weakened – there is now less than one job per applicant (0.93 jobs as of Apr08,
to be precise), and the unemployment rate stands at 4.0%, compared to a low
of 3.6% in mid-2007. Now that labour market conditions are past their peak,
there is virtually no chance of positive wage growth in the foreseeable future
(Chart 6).
Chart 5: Wage growth to remain stagnant
% YoY, 3mma
8
6
4
2
0
-2
-4
-6
Nominal cash
earnings
Inflation adjusted
Latest: Apr08
Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06
Chart 6: Unemployment is rising again
% Ratio
6.0
0.0
Unemp rate sa
5.5
0.2
5.0
4.5
0.4
4.0
0.6
3.5
0.8
3.0
Job-applic ratio,
1.0
2.5
sa (RHS, inv)
2.0
1.2
1.5
1.4
1.0
Latest: Apr08
1.6
Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06
Consumer spending will slow
The lack of wage growth going forward is a negative for the consumer spending
outlook, and in the remaining three quarters of the year we expect real private
consumption expenditure (PCE) to drop back to around 0.1% QoQ, from an
unusually strong 0.8% QoQ rise in 1Q08. For the full year, PCE will slow to 1.4%
from 1.5% in 2007.
Inflation is hurting
consumers
Going forward, households will have to continue grappling not only with wage
stagnation, but also, as is the case with the corporate sector, rising prices. Where
rising prices eat into firms’ margins, within the household sector they eat into
wage growth and purchasing power. Referring again to Chart 5, we can see that
after adjusting for inflation, wages in Apr08 were up only 0.2% YoY, versus a
nominal 0.8%.
144

Economics – Markets – Strategy
Economics: Japan
To be sure, headline inflation of around 1% YoY (as Japan has been experiencing
so far this year) is still very modest by most standards. But this small number,
combined with flat wages, deteriorating job prospects and increased economic
uncertainty overall has severely knocked the wind out of consumer sentiment
(Chart 7).
Chart 7: Consumer confidence jumps off the cliff
Index, nsa
51
49
47
45
43
41
39
37
35
Latest: Apr08
C'ser confidence,
all h'holds
nationwide
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08
Chart 8: Faster inflation ahead
% YoY
6
5
4
3
2
1
0
-1
-2
-3
-4
Corp goods pxs
Corp service pxs
Headline CPI
Latest: Apr08;
CGPI May08
Jan-02 Jul-03 Jan-05 Jul-06 Jan-08
In the months ahead, sentiment - and hence actual spending data - are set to
worsen further, given the likelihood that inflation will accelerate. The slower
headline inflation reading of 0.8% YoY in April reflected a 15% drop in gasoline
prices nationwide, after the government failed to renew a tax bill that expired
on April 1. The tax was, however, reinstated in May, meaning the slower inflation
reading was temporary. Furthermore, judging by how quickly wholesale prices
(as measured by the corporate goods price index) have surged above consumer
prices, firms will probably have more price increments to pass on to consumers
further down the road (Chart 8). Assuming that inflation heads back above 1%
YoY for most of the remainder of the year, then inflation this year should average
1.1%, compared to zero price gains in 2007. ‘Core’ inflation will closely match
the headline, since it excludes only fresh food prices; last year core inflation was
also at 0%.
Not much relief on
the inflation front,
with CPI due to rise
1.1% this year
BOJ to stand pat, eye on inflation expectations
The outlook we have painted above clearly looks anaemic, and for the year we
expect overall GDP growth to slow to 1.6%, from 2% in 2007. In quarter-onquarter
terms, growth will average 0.3%. Against this backdrop, the BOJ will
have no room to lift its overnight call target rate of 0.50% this year.
Rates will be kept
on hold this year
That said, the trend remains for higher inflation, however mild. More importantly,
longer-term expectations of future inflation – which are what policymakers
ultimately strive to keep stable - are also on the rise, and BOJ officials would no
doubt be keeping a close eye on developments on that front.
In its last two quarterly Opinion Surveys, there has been a swing in the percentage
of respondents who believe prices will rise, particularly on a one-year horizon.
In 3Q07, 71.7% of respondents believed prices would go up either slightly or
significantly in a year’s time; in 4Q07 and 1Q08 this percentage rose to around
86% (Charts 9). On a five-year horizon, the increase was less marked, from 82%
in 3Q07 to almost 85% by 1Q08 (Chart 10). In terms of the level of inflation,
respondents went from looking for a median 3% annual inflation rate in 3Q07
(on a one-year horizon), to around 5% in the 4Q07 and 1Q08 surveys.
Inflation, and
inflation
expectations, are
rising
145

Economics: Japan
Economics – Markets – Strategy
Chart 9: Outlook for prices, 1yr from date of survey
Sep-07
Survey
Dec-07
Mar-08
0% 20% 40% 60% 80% 100%
Will go up significantly
Will go up slightly
Will remain almost unchanged
Will go down slightly
Will go down significantly
Source: BOJ 33rd Opinion Survey on the General Public's Views and Behaviour
Chart 10: Outlook for prices, 5yrs from date of survey
Sep-07
Survey
Dec-07
Mar-08
0% 20% 40% 60% 80% 100%
Will go up significantly
Will go up slightly
Will remain almost unchanged
Will go down slightly
Will go down significantly
Source: BOJ 33rd Opinion Survey on the General Public's Views and Behaviour
The BOJ will lift
rates the first
chance it gets,
maybe as early as
1Q09
The rise in inflationary expectations, if persistent in the coming quarters, will
raise the odds of the central bank lifting interest rates at the earliest possible
opportunity. This could come as soon as economic data improves, possibly as
early as 1Q09. Although we have ‘downgraded’ the annual average YoY growth
rate for 2009 to 1.6%, in QoQ terms growth should actually average a relatively
stronger 0.7%. To that end, we continue to look for interest rate normalisation
to resume in 1Q09, with a modest 25bp hike in the overnight call rate target to
0.75%. This will be followed by a further 25bp hike in 2H09, taking the call rate
target to 1.0%.
146

Economics – Markets – Strategy
Economics: Japan
Japan Economic Indicators
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
GDP growth 2.0 1.6 1.6 1.0 0.3 -0.4 0.1 0.6 0.6
Private consumption 1.5 1.4 1.1 0.8 0.1 0.1 0.2 0.3 0.3
Pte resid & non-resid invest -0.1 -1.1 0.9 0.8 0.7 -1.8 -0.7 0.9 0.8
Government spending 0.1 -0.2 -0.9 -0.17 -0.3 -0.3 -0.2 -0.2 -0.2
Net exports (JPYbn, 00P) 26.2 33.1 39.7 7.0 7.6 7.9 8.3 8.6 8.9
Exports (G&S) 8.6 11.6 11.3 4.0 2.7 1.5 2.5 2.9 2.9
Imports (G&S) 1.8 5.3 7.0 1.4 2.0 2.0 1.8 1.5 1.5
External (nominal)
Merch exports (JPY trn) 84.1 89.1 93.5 21.3 22.8 22.4 22.5 22.2 23.9
- % YoY 11.8 5.9 5.0 5.0 9.0 4.9 4.7 4.0 4.5
Merch imports (JPY trn) 73.1 81.3 90.4 21.3 22.8 22.4 22.5 22.2 23.9
- % YoY 8.3 11.2 11.3 9.8 10.0 12.0 13.0 13.0 12.4
Merch trade balance (JPY trn) 11.0 7.8 3.0 2.1 2.9 1.9 0.9 0.5 1.5
Current acct balance (USD bn) 216.2 247.7 235.1 n.a. n.a. n.a. n.a. n.a. n.a.
% of GDP 4.8 4.9 4.6 n.a. n.a. n.a. n.a. n.a. n.a.
Inflation
CPI, % YoY 0.0 1.1 0.6 1.0 1.1 1.3 1.0 0.9 0.7
Other
Nominal GDP (USD bn) 4,462 5,050 5,123 n.a. n.a. n.a. n.a. n.a. n.a.
Unemployment rate (%, sa, ave) 3.9 4.3 4.5 n.a. n.a. n.a. n.a. n.a. n.a.
Foreign reserves (USD bn) 973 1,061 1,146 n.a. n.a. n.a. n.a. n.a. n.a.
* % change, period-on-period, seas adj, unless otherwise specified
JP – nominal exchange rate
JPY per USD
126
121
116
111
106
101
96
6/11/2007 10/10/2007 2/8/2008 6/10/2008
JP – policy rate
%, call rate
0.5
0.4
0.3
0.2
0.1
0.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
147

Economics: Eurozone
Economics – Markets – Strategy
EZ: ECB eyes wages
• 1Q08 GDP surprised on the upside thanks to investment growth. Exconstruction
GDP grew by 2.8% (QoQ, saar)
• Going forward, consumption should recover due to higher wages and help
keep growth near potential ( ~2%) in 2008 and probably in 2009 as well
• As consumption recovers and export growth remains healthy, high capacity
utilisation rates should support investment spending
• Euro strength has been a positive thus far, helping to curb imported supplyside
inflation. It has also supported Eurozone’s nominal USD import demand
and hence global growth in the face of US slowdown
• We expect one rate hike in Jul08. Wage developments are central to the
growth, inflation and interest rate outlook
1Q08 GDP exconstruction
grew
by 0.7% (QoQ, sa)
or 2.8% (saar)
1Q08 GDP review and summary outlook
1Q08 growth surprised on the upside at 0.8% (QoQ, sa) or 3.2% (QoQ, saar), led
by a surge in investment (10.7%). While temporary factors, such as mild weather
in Europe, pushed construction spending higher, ex-construction GDP also grew
by 0.7% (QoQ, sa) or 2.8% annualised. This reflects largely the strength of business
investment spending. Consumption spending recovered slightly from 4Q07 but
remained subdued (0.6%).
Going forward, investment growth should moderate and consumption should
pick up slowly and steadily in line with higher wages. This implies that overall
GDP growth should stay around potential. We continue to look for 2% GDP
growth in 2008 and 2009 (Chart 1 &2).
Both growth and inflation uncertainties remain high. Insufficient real wage
growth, further rise in commodity prices and higher interest rates are the main
downside risks to growth. While inflation risks lie to the upside, in the policy
relevant time horizon (18-24 months), we think inflation risks are not material.
EUROZONE
Chart 1: GDP growth - around potential
%, YoY, annual data
6
5
4
3
2
Potential GDP
1
0
-1
1992 1994 1996 1998 2000 2002 2004 2006 2008F
Chart 2: Contributions to GDP growth
%-pts, QoQ, saar
4
3
2
1
0
-1
-2
Mar-04 Mar-06 Mar-08
Pvt Consmptn
Invst exp
GDP
DBS
F'cast
Govt exp
Net Exports
Ramya Suryanarayanan • (65) 6878 5282 • ramya@dbs.com
148

Economics – Markets – Strategy
Economics: Eurozone
Consumption supported by strong labour market
While higher food and fuel prices have hurt sentiment and demand in 4Q07 and
1Q08, sentiment is still better than average 2000-07 levels, and even above 2004
level. Both periods saw average quarterly growth of 1.5% in consumption (QoQ,
smoothed). A comparison of US and Eurozone consumer confidence also shows
that while both indices are falling, Eurozone’s index is still at elevated levels
(Chart 3).
Importantly, the labour market is still supportive of wages, and unemployment
is at decade lows (Chart 4). High level of unionisation of labour also supports
wage growth in the face of rising prices. In Germany, for example, wage negotiations
concluded thus far have ended with circa 5% rise in wages in 2008. This is well
above the 3% average inflation expected in 2008. As such, we are comfortable
with our forecast for 1.1% (QoQ, saar) and 1.5% quarterly consumption growth
in 2008 and 2009.
Consumption
should pick up with
higher wages
keeping growth
near potential
Chart 3: Consumer confidence
Chart 4: Unemployment to stay at decade lows
EZ Index
5
0
-5
-10
EZ (LHS)
2000-07 avg
(EZ:-10, US:90)
US (RHS)
US Index
119
109
99
89
%, sa
11
10
9
-15
79
8
-20
69
Latest: May08
-25
59
May-00 May-02 May-04 May-06 May-08
7
Latest: Apr08
6
Jan-93 Jan-97 Jan-01 Jan-05 Jan-09
Investment - consumption pick up and capacity utilisation support
As consumption recovers and remains supportive of growth, the elevated levels
of capacity utilisation should drive investment spending (Chart 5). Despite falling
sharply, the business climate index remains above average of 2005 and 2000-07
Chart 5: Capacity utilisation vs investment spending
% % YoY
86
10
Chart 6: Business climate - better than 2004/05
Index
2
84
6
1
2000-07 avg
(~ 0.13)
82
2
0
80
-2
78
76
Capacity Utilisation
GCF % (RHS)
Mar-93 Mar-98 Mar-03 Mar-08
-6
-10
-1
Latest: May08
-2
May-00 May-02 May-04 May-06 May-08
149

Economics: Eurozone
Economics – Markets – Strategy
levels (Chart 6). Despite higher input costs, that corporate earnings growth still
rose by 9% (YoY) in Apr08 for companies listed in the Dow Jones EURO STOXX
index. Interest rates are also not at restrictive levels. On the whole, we expect
investment to still support growth.
Exports are a key support
Export growth has been a key support for growth in 2006 and 2007. Net exports
has added 0.9%-pt and 0.2%-pt to the full year GDP growth rate in 2006 and
2007. In 2008, we expect net exports to continue to add 0.2%-pt to growth, thus
playing a key role in keeping overall growth around potential. One factor that
is overemphasized with regards to export growth rate is the strength of the
euro. In the present context, we do not read euro strength as a negative.
Euro strength has
helped Eurozone
support global
growth and curb
inflation in the face
of US slowdown
Euro strength - is it good or bad?
In 1Q08, the euro was up circa 8% (YoY) in real trade weighted terms or real
effective exchange rate (REER) terms. Higher input costs and a strengthening
euro are often together cited as negative factors for exports. However, a strengthening
euro acts in opposition to higher input costs in practice. If the euro were not
stronger, exporters’ margins would anyway be lowered by higher input costs.
Pointing to EUR strength as a separate negative is, therefore, not meaningful.
Indeed, despite a strengthening euro, export growth (Chart 7) held up in 1Q08
at around 5% (YoY and QoQ, saar, 2qma). This is hardly an evidence of erosion
of export competitiveness. In contrast, in 2003, when the euro had strengthened
by 12% in REER terms, exports hardly grew.
In fact, to the extent that a stronger EUR helps curb inflation and support purchasing
power in the Eurozone, we see the stronger euro as a positive. One of the biggest
benefits of a stronger euro is that it helps cushion the global economy (and by
extension the Eurozone) from the drag of a slowing US economy. In terms of
pure size, Eurozone economy has almost doubled in nominal USD terms in 2008
compared to 2000 - USD 13trn vs USD 6trn. Thus, from being about 60% the size
of the US, the Eurozone has expanded to almost 90% the size of the US.
Of course, this is not a structural change, but rather a cyclical currency led change.
Yet, this has helped the Eurozone play a major role in supporting global demand
growth and offset slowing US demand. This is especially evident if we consider
the growth in GDP in nominal USD terms which is relevant as an indication of
strength of Eurozone’s import demand. Eurozone GDP grew by 16% in nominal
terms in 2007. If the EUR had not appreciated, GDP growth would have been
Chart 7: Annual real export growth
%, YoY, annual data
10
9
8
7
6
5
4
3
2
1
12% REER
growth
4Q07-1Q08 saw 8% (YoY) REER
growth & 5% export growth
2000 2002 2004 2006 2008F
Chart 8: EZ GDP growth - stronger EUR cushions
US slowdown
% p.a, nom GDP, USD
20
GDP (EUR/USD at 2004 level:1.24)
GDP (prevailing EUR/USD rates)
16
12
8
4
0
2005 2006 2007 2008F
150

Economics – Markets – Strategy
Economics: Eurozone
only 5% (Chart 8). This also meant that a quarter of global GDP growth in 2007
came from the Eurozone even as the contribution of the US fell to a mere 12%.
Inflation and monetary policy - one 25bp rate in July
Inflation should average 3% in 2008 assuming we see oil prices moderate another
10%-15% from the levels prevailing in May08. However, if prices continue to
rise, inflation should surprise on the upside in 2008 and 2009. The longer term
inflation outlook depends also on how consumers adapt to the higher prices
and whether higher wages prove sufficient to cope with higher prices. After the
May08 policy communication when the ECB signalled a rate hike in the upcoming
meeting, we added a 25bps hike to the rate call for 3Q08. This is expected to
come in July as long as oil prices do not decline sharply. On the other hand, if
oil prices drop dramatically, rate hike bets should be off. To be sure, as long as
growth stays not far from potential (2.0%-2.25%), the ECB can justify an “insurance”
rate hike to control inflation expectations. This is why we did not spell out any
rate cuts in our monetary policy trajectory previously. We do not think one or
two rate hikes would derail growth. However, a series of rate hikes taking policy
interest rates towards 5% is quite likely to slow growth.
We expect one
rate hike in Jul08
and remain
unwilling to pencil
in rate cuts in the
medium-term
151

Economics: Eurozone
Economics – Markets – Strategy
Eurozone Economic Indicators
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f
Real output and demand
GDP growth (00P) 2.6 2.0 2.0 3.2 0.6 2.2 2.2 2.0 2.1
Private consumption 1.6 0.9 1.4 0.6 0.8 1.3 1.5 1.5 1.5
Government consumption 2.3 1.6 2.0 1.5 2.2 2.2 2.2 1.8 2.0
Gross capital formation 4.3 3.7 3.0 10.7 -2.0 4.0 4.0 3.0 3.0
Net exports (EURbn) 123 137 148 33 34 36 37 37 37
Exports (G&S) 6 5 4 8 4 4 4 4 4
Imports (G&S) 5 4 4 7 4 4 4 4 4
External (nominal)
Merch exports (EURbn) 1504 1617 1716 387 404 407 419 413 429
- % YoY 8 8 6 7 8 8 7 7 6
Merch imports (EURbn) 1448 1546 1618 389 376 378 402 408 5
- % YoY 6 7 5 10 6 5 5 5 5
Trade balance (EUR bn) 56 71 98 -3 28 28 17 5 35
Current account balance (USD bn) 26 46 86 n.a. n.a. n.a. n.a. n.a. n.a.
% of GDP 0.2 0.3 0.6 n.a. n.a. n.a. n.a. n.a. n.a.
Inflation
HICP (harmonized, % YoY) 2.1 3.0 2.1 3.3 3.4 3.1 2.2 1.8 1.7
Other
Nominal GDP (USD tn) 12.2 14.2 13.6 n.a. n.a. n.a. n.a. n.a. n.a.
Unemployment rate (%, sa, eop) 7.2 7.2 7.2 7.1 7.2 7.2 7.2 7.2 7.2
EU – nominal exchange rate
USD per EUR
1.56
1.53
1.50
1.47
1.44
1.41
1.38
1.35
1.32
1.29
3/12/2007 7/11/2007 11/9/2007 3/11/2008
EU – policy rate
%, refi rate
6.0
5.0
4.0
3.0
2.0
1.0
Jan-01 Nov-02 Sep-04 Jul-06 May-08
Sources for charts and tables are CEIC, Bloomberg and DBS Research (forecasts and data transformations)
152

Economics – Markets – Strategy 3Q 2008
General Client Contacts
DBS Singapore (65) 6878 8888
DBS Bangkok (66 2) 636 6364/5
DBS Shanghai (86 21) 3896 8888
DBS Beijing (86 10) 6505 1216
DBS Guangzhou (86 20) 83497999
DBS Suzhou (86 512) 6288 8090
DBS Shenzhen (86 755) 8269 0880
DBS Fuzhou (86 591) 8754 4081
DBS Tianjin (86 22) 2339 3075
DBS Hangzhou (86 571) 8788 1288
DBS Dongguan (86 769) 2211 7868
DBS Hong Kong (852) 2868 8822
DBS Kuala Lumpur (60 3) 2148 8038
DBS Labuan (60 87) 595 500
DBS KLMO (60 3) 2148 8338
DBS Manila (63 2) 845 5112
DBS Seoul (82 2) 6322-2660
DBS Taipei (886 2) 8101 0598
DBS Taoyuan (886 3) 339 6060
DBS Chungching (886 4) 2296 0088
DBS Taichung (886 4) 2230 9188
DBS Changhua (886 4) 728 4567
DBS Touliu (886 5) 537 2388
DBS Tainan (886 6) 213 3939
DBS Kaohsiung (886 7) 323 2362
DBS Tokyo (81 3) 3213 4411
DBS Jakarta (62 21) 390 3366
DBS Bandung (62 22) 427 1100
DBS Kelapa Gading (62 21) 4855 1267
DBS Kota (62 21) 2656 5788
DBS Medan (62 21) 457 7336
DBS Muara Karang (62 21) 2658 5255
DBS Pekanbaru (62 761) 889 188
DBS Pondok Indah (62 21) 2758 6688
DBS Semarang (62 24) 845 5008
DBS Surabaya (62 31) 532 9661
DBS Thamrin (62 21) 390 3366
DBS Tomang (62 21) 2556 6255
DBS Palembang (62 711) 35 0123
DBS Mumbai (91 22) 6638 8888
DBS Delhi (91 11) 3041 8888
DBS Dubai (97 14) 364 1800
DBS London (44 20) 7489 6550
DBS Los Angeles (1 213) 627 0222
Disclaimer:
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 information 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.