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Global Emerging Inflation? Germany Europe’s Last Growth Engine Sputters Asia Pacific ASEAN4: Coping with the Inflation Challenge View GEF Archive

		The Global Economics Team

			Elga Bartsch
Elga Bartsch is an Executive Director whose main research focus is the monetary policy of the European Central Bank.
		Read about other GEF team members

Thus, it’s critical for investors now to discriminate among emerging market economies by assessing the extent of their inflation problem and the resolve of central banks in emerging markets to tackle it.  Our global emerging markets team points out that there is significant variation on both counts, but also that there are important common themes:

•           First, our teams generally expect inflation to ease towards the end of the year, but only slowly.  This is partly because rising headline inflation has already boosted inflation expectations and thus has spilled over into wages and other prices, making an orderly transition to a stable, lower level of inflation more difficult.

•           Second, the commitment of central banks to fight inflation seems to vary according to the growth outlook – the weaker the outlook, the weaker the commitment – and whether the central bank has explicitly embraced an inflation target.

Thus, with the exception of China and Korea, our emerging markets team expects every single central bank under its coverage to raise rates by the end of the year.

But will this restraint tame inflation?  Our metrics provide some grounds for scepticism. Global policy rates are negative, with the nominal global policy rate currently at 4.4% and global inflation in May around 5%. In emerging markets, Latin America is the notable exception, with a real policy rate of 3.6%. Asia (ex-Japan) as well as the Emerging Europe, Middle East and North Africa region have negative real interest rates; this suggests to us that policy isn’t restrictive and any decline in inflation will need either stronger policy action or a helping hand from commodity markets and global growth, or both.

As important as it is to understand these common themes, they obscure the diversity of the inflation story in individual regions and markets.  In what follows, therefore, we turn to our emerging market teams to paint a more detailed picture of the inflation backdrop and the associated policy challenges.

EMEA: Some Help from Currencies, but More Hikes to Come

Russia and Ukraine: While underlying inflation pressure in Russia and Ukraine remains strong, we continue to think that headline inflation has already peaked as the food price surge begins to recede.  In Russia, policy-makers remain divided – with the Finance Ministry fighting a rearguard action for tighter policy – but we expect fiscal policy to remain stimulative.  Prime Minister Putin has explicitly contrasted the ECB’s willingness to sacrifice short-term growth for lower inflation with Russia’s stress on growth.  Meanwhile, as in Ukraine, ongoing administered energy price hikes and a very tight labour market, driven by a declining labour force, are likely to keep core inflation pressure rising.  We expect the main policy response in Russia to be a shift towards a wider RUB corridor.  This would also make room for gradual further interest rate hikes – we continue to see the overnight repo rate reaching 8.5% by end-2009.  In Ukraine, a very strong grain harvest – up more than 50% on last year – should bring headline inflation down to around 23% by year-end (food accounts for 55% of the consumer basket). However, the National Bank has little scope for a further FX response, we think, given a rapidly weakening balance of payments position.

Central Europe: Inflation in the region is at or close to its peak, but central banks everywhere are still worried about the threat of second-round effects and the prospect of inflation getting stuck at levels well above target. Nominal FX appreciation has brought some relief, tightening monetary conditions significantly via the exchange rate channel. FX gains and increasing evidence of a growth slowdown in sync with Western Europe have prompted central banks across the region to indicate that the tightening cycle may not have much further to run. Indeed, for the first time in quite a while, we see downside risks to our policy forecasts. In the Czech Republic, continued CZK gains versus the euro (+11% year-to-date), together with the recent softening of the data, skew the risks to our call for 50bp of additional hikes by the CNB in 2H08 (peak: 4.25%) to the downside; in Hungary, the NBH surprised us and the market by staying on hold in June, and we think that it will wait to raise rates again until at least August (again, we see downside risks to our forecast of an additional 50bp of rate hikes to 9%, mainly due to the strong HUF); in Poland, we still feel confident that the NBP will tighten once again (September/October), but the NBP may then refrain from further hikes, though we think that cuts are a distant prospect and see rates holding at 6.25% throughout next year on risks of sticky CPI. In Slovakia, we expect the NBS policy to follow ECB policy in the months to come (the country will join EMU in January 2009 and rates are now on par with the ECB, at 4.25%).

Turkey: Inflation-targeting had not been a success in recent years, with the CBT missing the 4% target consistently, mostly because of food and energy prices. We expect the headline CPI of 10.6%Y as of June to peak at around 12%Y before easing to 7.2% at year-end, and easing again in 2009 due to higher interest rates, slower growth and commodity price stability. The CBT had been tightening monetary policy, and we expect the policy rate to reach 16.75% this year, with no easing until 2Q09. In our view, the CBT is highly committed to bringing inflation down and, if expectations as well as headline inflation remain sticky, the bank would not hesitate to tighten further. That said, the revision of the inflation targets (revised in the past to 7.5% for 2009, 6.5% for 2010 and 5.5% for 2011) is likely to provide some more breathing space for the CBT.

Israel: Headline CPI inflation as of May 2008 stood at 5.4%Y (official inflation target band of 1-3%). The main driver of inflation has been food, and second-round effects started to appear recently. We expect inflation to peak around 5.5% and predict a decline later in the year to the 3.5-4% range, with inflation entering the target band in 2009. While price stability seems to be a top priority for the BoI, attention is also being paid to economic growth; therefore, we expect the tightening to be rather limited unless the credibility gap widens noticeably. The BoI’s rate cuts earlier in the year (-100bp) on a weaker outlook have been followed by 50bp of tightening. We expect rates to rise an additional 25bp to 4% (with risks to the upside), and to 4.5% in 2009 as the Fed starts hiking.

South Africa: The inflation profile continues to deteriorate as oil prices trudge higher and hikes in electricity tariffs further boost the overall rate. We now expect CPIX to peak at 13.8% in November 2008, and fall back to the 3-6% target range no earlier than 3Q11. This is close to 200bp higher than the SARB indicated at the previous MPC meeting, and would represent a further four-quarter extension of the SARB’s ‘tolerance period’.  Unfortunately, for a strict inflation-targeting central bank such as the SARB, inflation must take precedence over growth. However, we must admit that the sacrifice ratio between inflation and growth has become increasingly punitive in recent times. If this were to continue, we believe that the SARB could well settle for smaller interest rate hikes in clips of 25bp. The upshot: We believe that the SARB will continue to hike rates again in August, while accepting a longer tolerance period.

Nigeria: The Central Bank of Nigeria has indicated that it would like to introduce inflation-targeting next year. This would make it less tolerant of higher inflation readings, even before the new regime is in place. Inflation has continued to push higher, reaching 9.7% in May despite a series of interest rate hikes since last year, with 50bp more expected at the next meeting on August 5.

AXJ Inflation Challenge: Still No Quick Solution in Sight

Summary: Headline inflation in the AXJ region is now close to a 9.5-year high.  Headline and core inflation have accelerated to 7.3% and 3.8% in May 2008, from 3.8% and 2.2%, respectively, a year back. The rise in global commodity prices, above-trend GDP growth, a cyclical shortage of skilled workers in certain pockets and a recent weakening of some of the currencies in the region have pushed inflation to a 9.5-year high. Where do we go from here? In our view, the trend in global commodity prices is the key. The message from oil and commodity markets is that there is a need for global aggregate demand to slow below-trend. With US growth having already slowed significantly, our US economics team does not expect the Fed to tighten until 2Q09. While some the EM central banks have begun to respond, the pace of the tightening is still not quick enough.

Similarly, in the AXJ region, the policy tightening is also gradual. Weighted-average 91-day T-bill rates (a proxy for effective short-term rates) are 5.4% currently, compared with headline inflation of 7.3% and core inflation of 3.8%. Although aggregate demand in the region is slowing, it is still very well supported by external as well as domestic demand. We estimate AXJ GDP growth in 1H08 at 8.5%, compared to the trailing five-year average of 7.8%. We broadly expect a “more of the same” kind of policy response from the central banks in the region. The risk is that if global commodity prices do not come off over the next 4-6 months, inflation expectations could rise significantly beyond the comfort of the central banks, and a more aggressive pace of tightening (relative to our base case) would be needed. 

China: Headline CPI has peaked, and we expect it to edge down in the remainder of the year, as food price inflation continues to ease while non-food price inflation – albeit low at below 2%Y – keeps creeping up. Going forward, the headline CPI trend will likely increasingly be influenced by the timing and magnitude of energy price deregulation. While a synchronised global slowdown poses a threat to China’s growth outlook, the sharp increase in international oil prices should force China to raise domestic energy prices despite the persistence of food price-driven inflation. In this context, energy price normalisation will likely replace currency appreciation as the primary driver in helping China’s growth rebalancing effort in the next 12 months. The policy challenge is to strike a delicate balance between supporting growth and preventing the second-round effect of ‘cost-push’ inflation by successfully anchoring inflation expectations. While asymmetric rate hikes could serve this purpose, we have doubts about its feasibility, because doing so will squeeze the banks’ NIMs when there is considerable uncertainty over their earnings outlook and asset quality. If inflation were to stay persistently high in the coming months as a result of domestic energy price increases, we argue that a ‘Government-Financed Inflation-Proof Deposits’ (GID) scheme – the objective of which is to manage inflation expectations – is a policy option of least resistance and thus more likely to be adopted than rate hikes.

India: WPI inflation has reached 11.6% (June 2008) and CPI inflation is 7.8% (May 2008). WPI inflation is significantly higher than the Reserve Bank of India’s (RBI) earlier stated comfort zone of 5-5.5%.  We believe that the government does not have much room to use fiscal measures or exchange rate policy to absorb the burden of higher commodity prices. We expect the RBI to lift policy rate by 50bp to 9% over the next three months. If commodity prices fall sharply by more than 20% in this period, the RBI may not make this move, in our view.

Indonesia: Headline inflation has reached 11% in June 2008. Indonesia continues to have the highest core inflation in the region, but it has one of the lowest short-term real rates. We expect the central bank to hike the policy rate by 100bp to 9.75% by year-end.

Korea: Inflation will continue to trend higher due to rising food and energy prices, in our view.  We expect inflation to peak at 6% in 3Q before it starts to ease, should global energy prices stabilise. The second-round effect of inflation is not seen yet, but the unionised labour force could pose a threat with hefty wage demands.  The rising social discontent with inflation and the US beef import issues could lead to active labour union activities again, putting Korea at risk of a price-wage spiral and therefore stagflation. Korea’s real interest rate is still positive, and is the highest in the region. We maintain our view that the Korean government will opt for FX and fiscal policies to fight this imported inflation, rather than raising the interest rate to slow down the whole economy.  If the BoK does not raise rates this month or next month, we believe that there will be no rate change this year; this is our base case scenario.

Taiwan: June inflation surprised largely on the upside at 5%, up from 3.7% in May.  When excluding food and energy, Taiwan’s CPI growth was actually still very low at 1.1% in June (or 1.2% year-to-date).  As a result, although we expect the central bank to continue to raise interest rates, we do not expect any aggressive hikes.  We look for a 12.5bp hike in each quarter, meaning a total of 25bp for the remainder of this year to bring the rediscount rate to 3.875% by year-end.

Latin America: Tighter Policy Where Growth Is Stronger

Latin America is facing significant inflationary pressure, which has prompted inflation-targeting central banks to tighten monetary policy across the region.  We see inflation splitting the region’s inflation-targeters into two groups.  In the first group are Brazil, Colombia and Peru, where above-potential growth is adding to global food and energy inflation.  In the second group are Mexico and Chile, where economic growth has been subdued but inflation has been on the rise, driven by the increase in international food and energy prices.  We expect the central banks in the first group to be more aggressive in tightening monetary policy in the months ahead.

Mexico’s central bank faces a complex balance between downside risks to growth, given its close link to the US economy, and mounting inflation pressures, largely from food prices. In addition to inflation (4.95% in May) having breached the 2-4% target range for three consecutive months, the recent inflation upturn has also put at risk the central bank’s inflation forecast path – unveiled on April 30 – in coming quarters and could prompt another upward revision on July 18.  Against this backdrop, we believe that the authorities are likely to deliver at least one more 25bp rate hike to shore up expectations, but a prolonged tightening cycle does not appear to be in the cards.

Inflation and inflation expectations have been on the rise in Brazil as well, with both pushing up against the upper bound of the inflation target range (2.5-6.5%). The median consensus forecast for 2008 inflation is now close to the 6.5% tolerance ceiling, and the consensus for 2009 inflation has increased toward the 5.0% mark, above the 4.5% target. The central bank has responded by hiking policy rates, with a 50bp move in April and another 50bp in June, to 12.25% currently.  Brazil’s central bank is concerned that the sharp food inflation rise could contaminate broader price formation dynamics, particularly against a backdrop of a strong expansion in domestic demand (8.1% in 1Q08).  Thus, while we expect a full tightening cycle of 300bp, with rates peaking at 14.25% by end-2008, we see upside risks this forecast.  In fact, our Taylor Rule exercise suggests that the central bank may hike by as much as a total of 400-500bp.

In Colombia and Peru, the inflation outlook remains challenging, with inflation above target for many months.  In Colombia, inflation has accelerated to 7.2% in June and has been above the 3.5-4.5% target range for 19 consecutive months, while in Peru inflation has reached 5.7% in June after breaching the 1-3% inflation target range for nine months. 

In both countries, inflationary pressure stems from growth running ahead of itself, and is further compounded by global food and energy inflation.  The central banks in both countries have responded by raising interest rates.  In Colombia, the policy interest rate is now at 9.75% after a cumulative 275bp increase since April 2006; while in Peru the target rate is 5.75% after a cumulative 125bp of hikes since July 2007.  We expect both central banks to continue hiking their overnight rates.

Bad inflation releases have become the norm in Chile, where it is running at a 14-year high (9.5%), despite a subdued growth backdrop.  Importantly, the food and energy price rises that initially drove inflation higher seem to be spreading into other prices.  In response, the central bank has been forced to resume its tightening cycle at a more aggressive pace – after staying on hold for four months and shifting to a neutral bias – by delivering a 50bp hike in June.  Hawkish comments by central bank officials reinforce our view that high inflation, signs of contamination beyond food and energy and rising inflation expectations should result in further monetary policy tightening by the central bank.

Germany
Europe’s Last Growth Engine Sputters
July 11, 2008

By Elga Bartsch | London

There is no mistaking the sharp slowdown of the export-driven German economy. Over the last few days, we have seen the sixth consecutive decline in manufacturing orders, which have now lost 5.6% from their November 2007 peak. We saw industrial production nose-dive 2.4%M in May, one of the five biggest monthly drops registered since reunification and the sharpest fall since August 1997. We saw exports fall 3.2%M in May, and they are now tracking a quarterly contraction of 1.6%Q during the second quarter.  A series of weaker-than-expected monthly activity indicators underpins our below-consensus call of an outright contraction in headline GDP by an annualised 1.7%Q between March and June. Note that this weakness is not confined to Germany. Similar sharp declines in industrial production were reported in France, Italy and Sweden.

The margin by which Germany outperforms the euro area seems to be melting away.  After a full-year GDP growth rate of 2.3% in 2008, on our estimates, which would put Germany’s pace of growth 50% above the euro area as a whole, we expect the German GDP growth rate to gravitate towards the euro area’s 1% next year. On a like-for-like, calendar-adjusted basis, we forecast Germany to expand by 1.3%, slightly below its trend rate of growth. This compares to 1.0% for the euro area – less than half of the trend rate for the region. The official German GDP data, which are not calendar-adjusted, would only show a growth rate of 1.1%, though.

Despite convergence in headline GDP growth, fundamentals remain different.   With the headwinds for housing-fuelled, debt-driven and consumer construction-led growth models at the European periphery still gathering momentum, the absence of such a hang-over from the past excesses should be a positive factor for Germany in weathering this downturn. In addition, a general election is looming in autumn 2009 and fiscal policy seems set to turn somewhat more expansionary in the run-up to this. The sudden weakness in German industry is more likely to reflect that the global slowdown is becoming more pronounced and more widespread. Today, the German economy is much more open than it was ten years ago. Exports and imports of goods and services account for 86% of overall GDP, compared to 45% in the early 1990s. This makes the German economy more susceptible to the gyrations of the global trade cycle.

True, some cyclical clouds are closing in on Germany’s horizon. But this should not divert attention from the structural turnaround of Europe’s largest economy. While the increased openness of the German economy clearly implies a greater sensitivity to the global trade cycle, it is also a key driver of the restructuring progress witnessed over the last few years. Integration into the international division of labour allows companies to focus on their comparative strength and forces them to earn their place in global markets. In my mind, it is key to distinguish between the cyclical deterioration (which in Germany’s case seem to be mainly due to external factors such as slower global growth, stronger euro, higher commodity prices) and the structural turnaround of domestic economic conditions. It is not surprising that in the current environment of elevated inflation and interest rates, the recovery in construction investment and consumer spending remains timid. But in contrast to other European countries, it’s not dragging down domestic demand.

The weaker German macro data tie in nicely with two trade ideas. First, in the US my colleagues Abhijit Chakrabortti and Jason Todd expect to see further portfolio rotation out of the global cyclical stocks (see US Portfolio Strategy – The Untouchables: Industrials Are Just Traditional Cyclicals, June 27, 2008). They think that this trend will continue to gain momentum as the focus shifts back towards rising global (and in particular emerging market) growth risks. Industrials are most exposed to immediate downside risk as the market continues to underestimate cyclical earnings pressures for the sector. As a result, they expect any further market weakness to be led by the global cyclical sectors and not financials, where earnings estimates and, especially, valuations are finally reflecting reality.

Second, closer to home, my colleagues Teun Draaisma, Graham Secker and Ronan Carr propose to go long the FTSE and short the DAX (see European Strategy: Buy FTSE, Sell Dax, February 18, 2008). While our European equity strategists rarely make explicit country recommendations, they recommend investors go long/overweight the FTSE and short/underweight the DAX on a 6-12-month view. The call is based on their expectation that global economic and profit growth will likely disappoint. In addition, a weaker GBP will favour the FTSE, while its greater cyclicality and higher-beta nature tends to thwart the DAX. Like their US counterparts, they also are heavily underweight industrials, tech, and materials and overweight defensives such as pharma and telcos.

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Asia Pacific
ASEAN4: Coping with the Inflation Challenge
July 11, 2008

By Chetan Ahya & Deyi Tan | Singapore, Shweta Singh | India

Setting the Global Context – Higher Now, Weaker Later

Since the onset of the credit crisis in 2007, global growth has surprised to the upside of market expectations. The Fed’s cycle-smoothing actions and the Treasury’s fiscal stimulus have averted a deep recession so far. However, a shallower downturn now seems likely to be followed by a more prolonged period of lackluster growth, with recovery pushed further back into 2009. Indeed, our US economists expect first half resilience to give way to recession (see The Perfect Storm Returns, Richard Berner and David Greenlaw, July 7, 2008) on the back of soaring energy prices, falling home prices, tighter financial conditions, global inflation and weaker global growth. US GDP growth forecasts have been adjusted higher for 2008 and lower for 2009 from 1.2% and 0.9% to 1.5% and 0.7%, respectively. Similarly, in Europe, our economists are seeing weaker prospects. 2008 and 2009 growth forecasts have been downgraded from 1.6% and 1.4% to 1.5% and 1.0%, respectively (see Oil Spike Shocks ECB into Action, by Eric Chaney, Elga Bartsch and Carlos E Caceres, June 11, 2008).

While growth momentum seems set to slow going forward, 1H08 macro soft decoupling had caused elevated inflation pressures to persist. The disinflationary era has likely ended (see AXJ’s Inflation Challenge, by Chetan Ahya and Qing Wang, May 28, 2008) and stagflation-like conditions are becoming more apparent.  In our view, high commodity prices are a result of ‘global overheating’. The global economy grew above trend at 4.6% in the past five years (versus the average of 4.0% since 1960s). Sustained commodity demand is now hitting against a supply brick-wall and commodity prices are likely to stay high until aggregate demand slows towards trend or below trend, in our view. Indeed, the source of inflation being more global than local has made it difficult for individual countries’ policy-makers to respond. The monetary policy response in the ASEAN region has been neither swift nor pre-emptive.

A stronger-than-expected global growth backdrop and relatively slow monetary policy response to emerging risks of inflation have resulted in 1H08 GDP growth in the region being mostly higher than our earlier forecasts. Headline and core inflation in ASEAN4 reached 8.1%Y and 5.7%Y as of May 2008, up from 3.5%Y and 2.9%Y 12 months back. However, the PPP-weighted average policy rate has been maintained at 5.4% as at June 2008 (versus 5.6% in June 2007). We believe that the policy tightening has continued to be slow relative to the strength of the aggregate demand and inflation pressures, and ASEAN economies will likely have to confront more monetary policy tightening going forward. In the above context, we are reviewing our ASEAN4 growth forecasts. We now expect 2008 GDP growth of 5.6% for the region, compared with our earlier forecast of 5.5%, and 2009 to be lower at 5.1% compared with 5.9% previously. We are maintaining our recently upgraded 2008 growth forecasts for Malaysia (5.7%) and Thailand (5.6%). We are revising our estimate for Indonesia (the largest economy in the region) from 5.5%Y to 6.0%Y, as underlying domestic demand momentum has come in stronger than our expectations, whereas we are revising downwards our 2008 forecast for Singapore from 5.1% to 4.3% to mark to market following the advance GDP estimate just released.

Facing Pressures on All Fronts to Varying Degrees

We believe that the outlook for all countries in the region looks challenging in 2009. A stagflation-like scenario with monetary policy tightening would mean that ASEAN economies face headwinds as higher inflation cuts into purchasing power and capex decisions, domestic demand weakens from policy tightening and export end-markets soften. In addition, some countries are facing idiosyncratic risks such as political uncertainty. As such, we are revising downwards our 2009 growth forecast to 5.1% from 5.9%. We forecast Indonesia’s GDP to fall to 5.4% in 2009 from an earlier estimated 6.2%. Similarly, we have cut our forecast for Malaysia from 5.7% to 5.2%, Singapore from 6.1% to 4.0% and Thailand from 5.5% to 5.0%. 

Rising Inflation Pressures and Policy Tightening

Headline inflation for ASEAN4 has spiked up to 8.1% in May from 3.5% in May 2007. Core inflation has also moved up to 5.7% in May from 2.9% a year back. High food and oil prices are bound to compound the inflation challenge in the region. The combined weight of these two items is high for most countries in the region. Lesser-developed economies such as Indonesia and Thailand have food and energy weights in the consumption basket at 54% and 51%, respectively, while Singapore and Malaysia have it at a comparatively lower 33% and 44%, respectively. In terms of oil, Indonesia and Malaysia, with the lowest retail fuel prices (US$0.64/litre and US$0.83/litre, respectively) in the region, have recently adjusted retail fuel prices by the largest magnitude (+28.7% and +47.8%, respectively) as the government rolled back fuel subsidies in May and June. If international crude oil prices remain high, we believe that both Malaysia and Indonesia may need to hike domestic fuel prices again, further adding to pressure on inflation and spending power. In terms of food, a combination of distribution and hoarding issues have led producing countries such as Indonesia and Thailand to have higher food inflation than in Singapore, where currency appreciation has helped to combat imported inflation somewhat. Food inflation for the ASEAN4 combined has accelerated to 13.6% in May from 6.4% a year back.

Such cost-push inflation has the greatest possibility of spiraling into second-round effects in Indonesia, which has been the strongest domestic demand story on the back of a credit cycle. Core inflation in the region is highest in Indonesia. We expect to see the largest amount of monetary policy tightening in Indonesia, with the central bank tightening from 8.75% currently to 9.75% by year-end. In our view, if the central bank does not move quickly to ensure higher lending rates and slower credit growth, high inflation and the resulting pressures on currency could lead to risks of a disruptive rate tightening in 4Q08 and unwind the credit growth cycle that had been underway.

Apart from Indonesia, we also expect Bank of Thailand, which has in the past been focused on managing inflation within its stated comfort zone, to tighten its policy rates by 100bp to 4.25% by year-end, an upward revision from our initial policy rate forecast of 4%. We expect the BoT to get back on the tightening path even as the growth trend appears to have moderated somewhat.  For Singapore, we believe that the central bank is likely to maintain the status quo of gradual and modest appreciation in the October 2008 review following two previous rounds of tightening adjustments in October 2007 (steepening the appreciation slope) and April 2008 (resetting the mid-point of the policy band). We expect Bank Negara (which does not explicitly target inflation) to have the least degree of tightening (50-75bp hike by year-end) relative to its growth and inflation conditions. Going forward, oil futures are indicating that prices will level off and stay at US$140/bbl levels and, on that basis, oil price inflation will likely peak out in 4Q08, potentially bringing headline inflation down as well. This is particularly so for economies with retail fuel prices which are marked to market. Coupled with the external slowdown, this is why we do not expect policy tightening in the region to be overly aggressive, though such policy actions will still weigh adversely on domestic demand growth.

The Coming Slowdown in External Demand

While our US economics team has recently adjusted upwards its growth estimates for 2008 to 1.5% from 1.2% to take account of 1H08 resilience, it has further cut its 2009 growth numbers from 0.9% to 0.7%. Similarly, in Europe, we expect GDP growth to slow to 1.0% in 2009 from 1.5% in 2008. While the region has continued to benefit from high exports to other emerging markets, we believe that some amount of downside is inevitable in 2009, particularly from Asia. In this context, we believe that Singapore is likely to face the maximum adverse knock-on effect of a slowdown in external demand. Singapore’s growth strategy has been fully centered on catering to global demand. However, a divergence has opened up between capex and foreign trade trends due to the broad-based construction boom (residential, office, transport, tourism infrastructure and retail). We expect this to help cushion the slowdown for 2008. However, our concern is for 2009. With the real estate market softening, support from construction will likely wane at a time when external conditions soften further.

Malaysia and Thailand are ranked second and third in terms of adverse impact from external slowdown, with exports/GDP ratios of 94% and 62%, respectively. Indonesia would be the least impacted from the potential foreign trade slowdown.

However, Indonesia and Malaysia are the bigger commodity producers, and would be negatively impacted if the global slowdown manifests itself in the form of a sharp fall in commodity prices in 2009.

Idiosyncratic Factors Increase Downside Risks

Malaysia’s transition to a truly two-party political system will make it a more interesting market in the long term, in our view. However, the possibility of protracted uncertainty in the transitional period could serve to dampen market sentiment, even as the real economy stays relatively protected on growth downside on the back of elevated commodity prices. Thailand also faces political uncertainties in the near term. Indonesia is likely to face a slowdown in reforms and market concerns could increase in the run-up to legislative (April 2009) and presidential (July 2009) elections. Singapore is the only country in the region where political conditions are stable and predictable. Hence, while Singapore would face the most pain from a global slowdown, we believe that it faces the least uncertainty in terms of what could go wrong relative to market expectations.

Bottom Line

We believe that the ASEAN region is likely to deliver higher-than-expected growth in 2008. Indeed, we are slightly (30bp) higher than our estimate in December 2007, when we argued for a relatively optimistic growth forecast due to soft decoupling. However, 2009 growth is now likely to be lower than earlier estimates. Inflation concerns will force more monetary policy tightening in the region, slowing domestic demand. Moreover, we believe that the weaker-than-expected US growth outlook for 2009 will adversely affect the external demand for the region. Our Europe economics team is also looking for a further growth deceleration in 2009. With these changes, our 5.1% 2009 growth forecasts for ASEAN4 are lower than the consensus estimate of 5.5%. In terms of risk profile, we see upside risks to inflation if the current degree of global slowdown is not sufficient to ease the commodity demand-supply mismatch. On the other hand, growth risks are skewed to the downside from further potential weakness in external demand conditions and more monetary policy tightening if inflation pressures stay elevated.

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