Central Europe
Not So Fast Anymore: Downgrading the Outlook
October 09, 2008

By Pasquale Diana | London

We are downgrading our growth outlook across Central Europe. Our euro area team’s sharp downgrades to the growth outlook for core Europe (see A More Severe Downturn, October 3, 2008) prompted us to revisit the macro outlook for the Czech Republic, Hungary, Poland and Romania. In addition to the weaker exports and investment outlook, evidence of severe strains on the credit market will likely take a toll on consumer credit growth, to a more severe extent than we envisaged so far. The result will be significantly slower growth across the board in 2009, and reaction from the monetary policy authorities in the form of rate cuts where the currency allows it.

The Obvious Link: Trade Flows

Our euro area team now expects a recession in core Europe, with annualized quarter-on-quarter growth set to remain negative for four consecutive quarters (2Q08-1Q09). Our colleagues in the US and Asia also downgraded their growth outlooks. This is bound to affect the exports and investment outlook across Central Europe (CE), particularly in those countries where domestic demand has been weak (Hungary) or has weakened substantially (the Czech Republic) and net exports were the main growth engine. These are also the most open economies across the region, though no country will be immune, of course. The overall impact on GDP growth (and the trade position) will be cushioned by the fact that CE exports usually have a high import content, and so import growth will ease also.

Nowhere are the trade linkages more obvious than in the auto sector. Over the last few years, large car manufacturers set up plants in Central and Eastern Europe to take advantage of cheaper labor costs, attractive tax rates, investment incentives and advantageous locations. The transport equipment sector now accounts for roughly 50% of all exports and around 10% of gross value-added across Central Europe (a lot of components are imported for re-export to Western markets). The recent slide in EU car sales is bound to have repercussions for car manufacturers in the region. Already VW Skoda has announced cutbacks in production in the rest of this year on the back of weaker 2H08 demand. Meanwhile, in Poland, GM/Opel announced a production break between October 20-31, due to lower demand in Europe.

The Less Obvious Link: Credit

As we stated above, open economies with weaker domestic demand dynamics (the Czech Republic and Hungary) look more vulnerable. However, it would be wrong to assume that this is purely an external shock. Domestic demand components like investment are bound to suffer if Western European (and local) corporates retrench and FDI flows dry up. Also, the ongoing credit crunch is highly likely to hit the region, though with a delay. Credit dynamics are already slowing, albeit at a benign pace. The real risk is that the Western European banks that have financed the recent credit boom are forced to curtail lending tout court, even in fast-growth areas like Emerging Europe. While we have been stressing these issues for several months (see FX Loans Give Central Banks Plenty to Worry About, June 13, 2008), the recent deterioration on the outlook for the European banking sector has increased the risks of a much sharper slowdown in credit than what we are seeing right now.

Loans/deposits ratios, especially in Hungary and Romania, are well above 100%, which implies that local banks have to go to the wholesale market or receive funds from the parent bank in Western Europe in order to finance lending. With wholesale markets practically shut, and Western European banks having issues raising capital, financing has become problematic (and will likely remain so for a while). We believe that credit growth will ease meaningfully over the next few months, though as our banking analysts note, the central bank at least in Romania could try to cushion the effect of a sharp slowdown by lowering the currently high reserve requirements (presently 40% on FX loans, 20% on RON loans), which would free up funds for domestic lending.

We also note that a great deal of the new loans have been granted in FX (EUR, CHF, even JPY), with borrowers enjoying the lower interest payments on the foreign-currency loan. This is especially a feature of Hungary and Romania, where FX loans represent most of new borrowing and 48% and 55% of the total stock of household loans, respectively. Elsewhere, the ratios are lower (32% in Poland, negligible in the Czech Republic). The recent environment of risk-aversion has taken a toll on local currencies, which have depreciated against the majors. Currency weakness therefore translates into an immediate increase in monthly mortgage repayments – equivalent to an aggressive rate hike. Currencies whose C/A deficits are financed in substantial part by FX loans (again, Romania stands out) look particularly at risk to us.

More Dovish Central Banks Everywhere, with Some Important Caveats

Given the size of the growth revisions and the new ECB outlook, we have had to re-think the outlook for interest rates. We believe that central banks will be surprised by bleaker-than-forecast growth everywhere, and inflation is set to move lower due to base effects as well as weaker growth. However, the picture is far from uniform, as the ongoing adverse risk environment could continue to take its toll on regional currencies, which have depreciated sharply against the USD (not so much versus the EUR). This is likely to mute what would have otherwise been a very aggressive easing cycle, because central banks will be wary of cutting rates at a time where their currencies are vulnerable.

•           In the Czech Republic, the central bank was well ahead of the pack in flagging downside risks to growth. Even so, we believe that there is scope for growth disappointment. In addition, the expected easing by the ECB will make the CNB’s job easier, as the Czech central bank will not have to worry about a widening negative rate differential when it cuts rates. We now see Czech rates a full percentage point lower than previously at end-2009 (2.25% versus 3.25%).

•           In Hungary, the growth outlook for next year looks bleak. We believe that growth will struggle to exceed 1%, which implies that Hungary will continue to bounce along the bottom and experience its third consecutive year of weak growth. As the economy struggles to come out of its low growth rut, inflationary pressures should be subdued, despite the likely pressures on the currency. We believe that the NBH will have scope to ease, provided (as in Romania, see later) it does not feel that rate cuts weaken HUF excessively. Our forecasts are 8.5% at end-2008 and 7.0% at end-2009.

  •          In Poland, we believe that the NBP will be surprised by weak growth data, and inflation also looks likely to be lower than we previously thought. That said, the prospect of joining ERM II at some point in 2009 complicates monetary policy decision-making. Under normal circumstances, the NBP would slash rates next year. However, the need to de facto target 2% inflation in 2010-11 to meet the Maastricht criterion implies that the bank will err on the side of caution. Taking on board our forecast revisions, we believe that the cycle has peaked, but the NBP will only deliver 50bp of rate cuts next year, less than priced into markets (100bp by end-2009). Our forecasts are 6% by end-2008 (but the risk of a final hike in October remains) and 5.50% by end-2009.

•           In Romania, we believe that the currency will continue to suffer in the near term, but the central bank will do its utmost to try to stop it breaching 4.00, including taking rates higher. Next year, we still expect growth to moderate substantially and the NBR to respond with rate cuts, assuming that it does not perceive the currency to be under threat. Our forecasts are 10.75% by end-2008 and 8.5% at end-2009.

South Africa
Implications of the Global Downturn
October 09, 2008

By Michael Kafe, CFA & Andrea Masia | Johannesburg

The credit crisis in the US and Europe appears likely to spark real economic weakness globally. Our global economics team has cut back on its GDP forecasts for the US, Europe and Asia (see US Economics: A Deeper Recession Goes Global, October 6, 2008; and Euroland Economics: A More Severe Downturn, October 3, 2008; ASEAN Economics: GDP Downgrades: How Bad Will the Cycle Get? September 29, 2008 and Japan Economics: Material GDP Downgrade, October 7, 2008). We now see global growth at 2.7% in 2009, down 0.8% from a month ago. Courtesy primarily of trade and financial shocks, we expect technical recessions in most of the industrialised world. For the US, we expect GDP growth of 1.3% in 2008 and -0.2% in 2009. This is down from earlier forecasts of 1.7% and 0.6% for 2008 and 2009, respectively, and reflects some three quarters of negative growth that we now expect to kick in from 3Q08. European GDP estimates have also been downgraded from 1.3% and 1% previously, to 1% and 0.2% for 2008 and 2009, respectively. We are now looking for an outright contraction in European economic activity until early next year. Similarly, in Asia, we expect Chinese GDP growth to fall from 10% to 9.8% and from 9% to 8.2% for 2008 and 2009, respectively. Finally, our Japanese economics team has lowered its GDP forecasts for 2008 from 0.8% to 0.4% and for 2009 from 0.2% to -1%. These downgrades have significant implications for South Africa.

First, it is important to note that South Africa is heavily exposed to European demand conditions, followed by Asia and then America. As much as 33% of South Africa’s exports are shipped to European destinations, and a further 30% go on to Asia. The US directly accounts for only 13% of South Africa’s exports. However, South African growth prospects could still take a knock from the echo effects associated with an indirect exposure to the US economy via Europe and Asia, as a US-led slowdown in these regions caps their demand for South African imports. Hence, a slowdown in the US, for whatever reason, has both direct and indirect implications for South Africa.

Although we have long held a bearish view on South Africa’s 2009 growth prospects, relative to consensus, we are inclined to downgrade further, given the much bleaker outlook on global growth. For South Africa, we now expect 2009 GDP to come in at 2.5% – down from our initial 3% call, to which consensus estimates have now fully migrated. We leave our 2008 forecast unchanged at 3.7%, as we believe that, although clearly waning, global demand conditions may still be strong enough to absorb cheaper exports from South Africa during the remainder of this year as the currency re-prices.  For 2010, we expect a reading of 3.7%, supported by FIFA World Cup expenditure and easier money.  Consensus estimates are 3.5%, 3% and 4.4%, respectively, for 2008-10.

Second, with weaker external demand and possibly lower commodity prices than initially expected, we believe that South Africa’s external payments position is bound to deteriorate further: export revenues for 2009 are likely to come in lower than thought, while 2010 FIFA World Cup-related capital imports (relatively insensitive to currency or interest rate movements) are likely to take up some of the anticipated slack in oil import spend. On the net invisible line of the current account, we look for some moderation in the momentum of dividend outflows as domestic growth slows and as foreigner investors continue to liquidate their holdings of South African assets. However, the services deficit is likely to be buoyed by net insurance and other service payments associated with a relatively high import bill. On the whole, therefore, we now expect the 2009 current account deficit to come in at 7.8% of GDP – up from 7.5% of GDP previously.

Third, with such a high current account deficit, funding issues become critical. We have on a number of occasions pointed out that South Africa relies rather heavily on fickle portfolio flows (mainly equities); and, in times of global risk-aversion, a dry-up in capital flows has often led to currency turmoil.  To be clear, our analysis shows that each time South Africa has reported an overall negative balance of payments position in excess of 2% of GDP since 1996, we saw major sell-offs in the rand either contemporaneously or shortly thereafter. This includes a 14.3% depreciation in 2Q96, a 20.5% depreciation in 3Q98 and a 23.5% depreciation in 3Q01. It is therefore worrisome that, after a positive inflow of R22.5 billion in 2Q08, portfolio investments swung to -R13.2 billion in July and August alone; and daily updates from Bloomberg point to a further R7.4 billion of outflows in September, implying that we could see more than R20 billion of outflows in 3Q08. With foreign appetite for SA investments having dwindled since August, we believe that it is only reasonable to expect direct investments and ‘net other investments’ (mainly short-term carry deposits) on the capital account to have dried up too.  Quite critically, this suggests that the overall external payments position may have been in record deficit in 3Q08.

Looking forward, we believe that the recent sell-off in the rand appears stretched, and may well be due for a short-term technical correction. However, economic fundamentals suggest that the rand should continue to trade on the back-foot in coming months. Importantly, the Medium Term Budget that will be presented to Parliament on October 21 is likely to show weaker growth, higher inflation, increases in the public sector borrowing requirement and a swing from fiscal surpluses by 2010. Such deteriorating fundamentals are likely to encourage further portfolio outflows. Also, as we head off into the elections in April 2009, political risk is likely to exert further upside pressure on $ZAR. On the back of these concerns, therefore, we are inclined to revise our USD/ZAR forecasts from 8.50, 9.0 and 9.20 at the end of 2008, 2009 and 2010, respectively, to 8.80, 9.50 and 9.80.  These revised forecasts are in line with our global currency team’s call for a stronger US dollar in 2009/10.

Finally, the weaker rand should exert upside pressure on inflation, preventing the SARB from cutting rates as quickly and as aggressively as the market expects.  We stick to our out-of-consensus view that the first bout of policy easing will only be delivered in August 2009, and not in February 2009 as priced in by the market. Our revised inflation forecasts show that inflation should fall back within the target range in 2Q10; however, our annual average readings for 2008 and 2009 now come in somewhat higher at 8.4%Y and 5.9%Y, respectively (i.e., up from 8.2%Y and 5.8%Y previously).

Conclusion

Downward revisions to global demand conditions have necessitated further downgrades to our already dim view on South Africa. Importantly, weak global growth will hurt South Africa’s external payments position, at a time where global risk-aversion is likely to rise. This should keep the currency under pressure, present further upside inflation risks and prevent the SARB from cutting rates as quickly and as aggressively as is currently discounted by the market.

ASEAN
More Downside as ‘Slowdown Goes Global’
October 09, 2008

By Chetan Ahya & Deyi Tan | Singapore & Shweta Singh | Mumbai

Further Downgrades as ‘Slowdown Goes Global’

For the earlier part of the year, decoupling was unfolding according to script and the rest of world (ROW) was in fact helping to support US GDP growth in 2Q08. However, the duration of the credit crunch in developed economies matters in terms of how long this could be sustained due to the inevitable feedback loop to ROW. Hence, we recently downgraded our ASEAN GDP growth forecasts to 5.4%Y and 4.1%Y from 5.6%Y and 5.1%Y for 2008 and 2009, respectively (see GDP Downgrades: How Bad Will the Cycle Get?, September 29, 2008).

Now, however, the re-evaluation of macro forecasts by our global colleagues shortly after our last downgrade has again opened up growth downside for ASEAN economies through trade and financial market linkages. Our US and Europe economists have made sizeable cuts to their numbers. The US GDP growth forecasts have been cut by 0.3ppt and 0.8ppt, respectively, to 1.4%Y and -0.2%Y for 2008 and 2009 (see A Deeper US Recession Goes Global by Richard Berner and David Greenlaw, October 6, 2008). For Europe, our forecasts have also been cut by 0.3ppt and 0.8ppt to 1.0%Y and 0.2%Y for 2008 and 2009, respectively (see A More Severe Downturn by Elga Batch and Carlos Caceres, October 3, 2008). Indeed, both our US and Europe forecasts are well below consensus expectations. The credit crunch in the developed world is also spilling over to Asia. Our China economist has similarly cut his growth forecasts by 0.2ppt and 0.8ppt to 9.8%Y and 8.2%Y, respectively.

With these, our base case is now officially a global recession scenario in 2009, with growth expected at 2.7%Y (versus the original 3.4%Y). In this regard, the assumptions underpinning our previous downgrades have changed significantly, and we no longer think that 4.1%Y growth in 2009 for ASEAN4 appropriately represents our central base case. As a result, we are further downgrading our 2009 numbers by 0.5ppt to 3.6%Y. We are leaving our 2008 numbers unchanged.

Significant Trade and Financial Market Linkages in ASEAN

Indeed, the spillover from the more significant global slowdown, which our team envisions will come directly through trade and financial market linkages. The exposure of each economy to these linkages form the backdrop for both the growth levels as well as the magnitude of growth deceleration we are expecting for 2009. Below, we rehash the sensitivity of ASEAN economies to these external linkages. The pecking order is Singapore, Malaysia, Thailand then Indonesia.

•           In terms of trade linkages, Singapore is the most exposed. In 2007, trade openness (measured as exports and imports) stand at about 350% of GDP. Its current account surplus stands at 24% of GDP. Malaysia has a similarly exposed economy with trade openness and current account surplus standing at 173% and 15.5% of GDP, respectively. On the other hand, Indonesia remains the least exposed in terms of trade within the region, with trade openness standing at 44% of GDP and current account balance at 2.4% in 2007.

•           In terms of asset market linkages, Singapore remains the most vulnerable as well. This is the result of the government’s efforts to develop the financial industry since the aftermath of the 1998 Asian financial crisis. Market capitalization stands at 260% of GDP as of June 2008. Not only do financial services constitute about 12% of Singapore’s GDP, the spillover from asset market linkages will also come in the form of negative wealth impact on investors as equity markets correct. In contrast, Indonesia remains the least exposed with market capitalization standing at 40.5% of GDP, which is the lowest in the region.

Three Key Negative Macro Trends for the Region

As we have been highlighting in previous notes, we see three key negative macro trends for the ASEAN region: First, the risk premia behaviour in ASEAN is fast catching up with the rest of the world. Capital inflows are slowing and cost of risk capital is rising. This will have the most impact on economies like Indonesia, which has the twin macro problems of a current account deficit and tight loan-to-deposit ratio. Even Singapore and Malaysia, which have favourable external balances, are not immune to the rise in funding costs. Second, autonomous macro support is likely to wane. In Singapore, property launches have slowed. The supply adjustments mean construction capex momentum is likely to taper off. The probability of active fiscal pump-priming in Malaysia and Thailand is also weakened by the lack of political stability for policy execution. Third, commodity producing EM economies are now seeing an erosion in the terms of trade, as commodity prices retreat. This means that the next leg of the slowdown is likely to come from the EM space, which has been a strong source of export demand in the face of the developed world slowdown. Moreover, Indonesia and Malaysia are net commodity producers.

Korea
It’s More Domestic Problems than Export
October 09, 2008

By Sharon Lam | Hong Kong

Summary and Conclusions

We have been relatively more constructive on the Korean economy, as we are confident in its competitive export sector.  The Korean economy’s outperformance of the other Tiger economies since 2006 supports our view.

That was then.  We still expect Korea’s export sector to hold up better than other exporters in the region, but the strong growth pace is unlikely to continue since the global liquidity crunch is beginning to eat into the real economies in both the developed and emerging markets.  More importantly, the domestic economy does not appear to have any strength to offset the export downturn, as exchange rate fluctuation is delaying a much needed rate cut into next year while credit growth drops and liquidity is clearly receding.

We are revising down our 2008 GDP growth forecast to 4.5% from 4.7% versus consensus forecast of 4.4%.  We are downgrading our 2009 GDP forecast more substantially to 3.8% from 5% versus consensus expectations of 4.3%.  Regarding the difference between our 2009 outlook versus the Street’s, we are more pessimistic on fixed investment (our -0.1% versus consensus +4%) and consumption (our +2% versus consensus +3.3%) but slightly more positive on export (our +5% versus consensus +4.6%).  We expect a bottom in 1Q09 when the economy could register a negative sequential growth rate, but we do not expect a recession.  Although growth is slowing, we expect Korea’s current account to swing back into surplus in 2009 from a deficit in 2008 due to a drop in import prices and a decline in overseas spending. 

We think the Street is still too hawkish about inflation in Korea.  We are keeping our 2008 CPI forecast unchanged at 4.5% but are revising down our 2009 forecast to 3% from 3.5%. We are expecting a total of 125bp interest rate cut by the central bank before the end of 2009 to bring the base rate from the current 5.25% to 4%.

There is no mistaking that the Korean economy is slowing as it is the case everywhere else in the world, but we are sticking to our view that it is not at a crisis level.

Korea’s Export Sector to Still Hold Up Better than Others

When the US subprime crisis started to break out last year, we had an out-of-consensus view that Korea’s export sector would be able to defend against the US slowdown.  Indeed, Korea’s export growth even surprised us on the upside.  Not only did its export growth not slow this year, it has grown even stronger.  By stripping out the price effect, Korea’s export volume growth jumped almost 14% during the seven months of the year as compared with a full-year 2007 growth rate of 11%. This marked a sharp contrast with the other major exporters in the region, which have already seen exports decelerate.  The strength in Korea’s exports this year has been in both heavy and light industries from machinery to electronics.

The question is can this export outperformance continue?  The answer lies in why Korea’s export sector was so strong to begin with.  Was it just temporary or secular?  I believe it is the latter.  First, Korea has a diversified industry profile from basic materials to industrials to consumer goods, and this makes it less vulnerable than countries with only one or two pillar industries.  Second, the financial crisis of 10 years ago and KRW appreciation have forced Korean exporters to restructure, and to keep moving up the value chain, upgrading their quality and brand image in order to maintain pricing power.  Korean products are gaining market share or have become leaders in many industries.  Last, but not least, Korean exporters have adopted what we view as the correct strategy in recent years by shifting away from G3 countries and selling to the high-growth economies instead, particularly China and Middle East.  On top of these is the bonus of KRW depreciation that only makes Korean exports even more competitive, especially against the Japanese.

That said, this does not mean that Korea’s export growth can continue at its current pace.  Export contributions from G3 are likely to drop to negative next year.  Our US team has cut its 2009 GDP forecast to -0.2% from an estimated 1.4% growth rate this year while also expecting three consecutive quarters of sequential negative growth from 3Q08 to 1Q09.  Meanwhile, our Europe 2009 GDP forecast has also been revised down substantially to a mere 0.3% from a projected 1.2% in 2008.  At the same time, demand from Middle East, Latam and partial ASEAN will also be under pressure along with the drop in commodity prices.  However, we contend that the above phenomenon does not apply only to Korea’s exports, but to all exporters. 

Yet, what is likely to keep Korea’s exports more resilient than others will be demand from China, in our view.  We shall not forget that no other country has penetrated the China boom as quickly and as successfully as the Koreans.  Korea is already the second-largest import source for China after Japan, and what is most important is that Korea is rapidly gaining market share in China while Japan is losing.  If this trend continues, Korea may even become China’s biggest import source in the near future, and this is extraordinary for Korea given the difference in their economic sizes.  Although our China economist, Qing Wang, has also revised down his 2009 GDP forecast to 8.2% from an estimated growth rate of 9.8% in 2008, he remains relatively positive about China’s macro stability due to potential stimulative measures from the Chinese government to support its domestic economy.  Given Korea’s strong position in China, Korea could be the foremost to benefit from solid growth in China.  While there is no official data on how much exports from Korea to China will be re-exported, we know it is not significant.  This can be implied from the fact that China’s year-to-date export growth in volume terms has almost halved the growth in 2007, but Korea’s exports to China have remained strong at +27% YTD compared to +17% in the same period last year, meaning that Korea’s exports to China are not sensitive to China’s export business, which is under challenges.  Korea’s exports to China cater more to China’s domestic economy, which is likely to remain firm with the appropriate policy response from its government.

Bottom line, export growth will slow in Korea, but we do not expect a complete meltdown due to: i) the strong core value of Korean products with brand recognition, yet selling at competitive prices; and ii) Korea’s successful position in China, which allows it to continue to leverage on the relatively sustainable solid growth in China.

Capex Would Be Under More Pressure

Without a collapse in the export sector as we predict, we believe that this export-oriented economy will not go into recession.  However, capex will still be under more pressure.  First, inventory growth in the manufacturing sector became excessive early this year, and will require a correction in capacity growth in the next two to three quarters along with slowing demand and production needs.  Second, we estimate that Korea has been relying significantly more on imports for its capex needs, and the KRW depreciation will clearly discourage capex, although it may be substituted by domestic capital goods suppliers but such adjustment takes time.  Finally, tight liquidity conditions will limit the credit available for working capital for the manufacturers.

We expect Korea’s facility investment to dip to negative growth in 2009, at -2.5% from an estimated 2.5% growth rate in 2008 − the first contraction since 2003.  Nevertheless, we believe that this will not lead to an economic recession, as the Koreans, in general, have been much more disciplined in their capital investment since the Asian financial crisis.  Indeed, the capex/GDP ratio is already at a 20-year low, which partly explains why capacity utilization has been hovering at historically high levels since 2004.  The coming decline in capex will be more of a cyclical adjustment rather than a correction of overcapacity, in our view.

Consumption Needs to Be Adjusted Too, but Not as Much as the Post-Credit Card Crisis

Against such a depressing global macro backdrop, consumers will undoubtedly tighten their purse strings.  Our leading indicator for retail sales shows consumption will not recover until 3Q09.  This leading indicator is a simple indicator of whether consumers have under- or over-consumed, and therefore what the subsequent adjustment in retail sales should be.  When income growth is rising faster than consumption (i.e., when the indicator is going up), it means that consumers are under-consuming, and vice versa.  There is a time lag for consumers to adjust their spending behavior accordingly, and therefore, we push this ‘income growth minus consumption growth’ by six quarters. We show that it does correlate very well with the direction of actual retail sales growth.  The Koreans have seen consumption grow faster than income in the past year, and that will lead to slower retail sales growth as households need to reduce their over-consumption.

On top of the adjustment in consumption due to income effect will be the decline in wealth as asset prices come under pressure.  Household consumption in Korea appears slightly more correlated with stock market changes rather than property prices.  The relative good news is that unlike the rally in 2001-02, the latest property market boom has not translated into any wealth effect on consumption, and the wealth effect from the stock market has also been limited. Therefore, the forthcoming adjustment in consumption should also be milder. 

The only near-term catalyst for consumption will be interest rate cuts to relieve debt service burden, but one or two cuts will not have much impact and so there will likely be a time lag before we see a bottom for consumption. We expect private consumption growth to slow to 2% in 2009 from a projected 2.2% in 2008. While we do not expect a contraction, we also see no visible recovery until late 2H09.

Inflation Has Peaked, Although the Moderation Will Be Slowed by KRW Depreciation

Inflation is a lagging indicator, and it lagged Korea’s GDP growth by about six months in the last three cycles.  Indeed, Korea’s CPI growth slowed to 5.1%Y in September from a peak of 5.9% in July.  The KRW depreciation will slow this moderation in inflation, but will not reverse the downward trend, in our view, unless the KRW/USD shoots up to 1,500, as the decline in oil prices since the peak in the summer has been almost 40%, which is faster than the KRW depreciation.  More importantly, only 20% of the goods that Korea consumes are imported.  Goods account for 47% of the CPI basket, and therefore only (47%*20%) 9.4% of Korea's CPI basket is sensitive to exchange rate changes, which can be easily offset by the decline in other prices. Housing is already 10% of the CPI basket, and housing rent is dropping.

Given the drop in oil prices and the projected decline in overseas travel and spending, coupled with our relatively more constructive view on Korea’s export growth than consensus, we expect Korea’s current account to swing back into surplus, starting this quarter and to widen further into next year.  Meanwhile, the financial account is likely to remain in deficit as foreigner investors continue to withdraw from Korea, but we believe that the pace of capital outflow will be slowed by Koreans redeeming their overseas equity investment.  Koreans had a net equity investment outflow of US$62 billion in the last 24 months, and it has started to see a net inflow since August. This should help relieve some concerns over exchange rates and inflation.

Policy Responses

On the monetary side, we expect the Bank of Korea (BOK) to cut interest rates by a total of 125bp before the end of 2009, which will bring the base rate from the current 5.25% to 4%.  However, Korea will have to act slower than other central banks in the region since the first cut is not likely until the KRW stabilizes to completely contain inflation worries.  We look for the first interest rate cut to come in January, but we do not rule out the possibility of policy moves before that if markets tumble further.  We also expect the BOK to lower the reserve requirement ratio on deposits soon to inject liquidity.

Korea also has a solid fiscal account to stimulate the economy, as it is the only country in the region that has run a fiscal surplus since 2001, and its government debt level is one of the lowest among OECD countries.  However, fiscal stimulus is constrained by the geopolitical threat of North Korea, which will weigh on South Korea’s sovereign rating if fiscal discipline is not maintained.  The personal and corporate income tax rate cuts announced in August and to be implemented in 2009/10 are not aggressive enough, in our view.  We hope the government will consider further cuts on personal income tax to stimulate the economy, and to bring forward the corporate tax cuts to be completed in 2009 instead of 2010.

The wild card of policy response could be further deregulation on the construction industry and lowering of property-related taxes, which, although they will not reverse the coming trend of property price declines, should at least help to stabilize the property market.  Such policy is currently constrained by inflation concerns since deregulation on the property markets may fuel inflation expectations again.  Once inflation comes down more substantially in 1Q09, the government will have more room to stimulate the construction industry.

Risks to our Forecasts

The biggest downside risks are i) KRW/USD overshooting to beyond 1,500 in a short period of time and thereby causing further delay in interest rate cuts; ii) a hard landing in the China economy; and iii) a collapse of the North Korean regime.  If one of these happens, we believe that South Korea will go into a recession in 2009, but a short one, if it is due to an exchange rate shock, but more prolonged, if it is due to the latter two factors.

Taiwan
Slow but Relatively Safe
October 09, 2008

By Sharon Lam | Hong Kong

Summary and Conclusions

Taiwan had a confidence problem, and it still does.  It is unfortunate that the beginning of domestic economic reforms in Taiwan has been met with a global recession that slaughtered sentiment.  A slowdown appears unavoidable now despite a proactive new government.  Nonetheless, we believe that the consistent and persistently supportive policies of the government will make a difference, i.e., they should help to avoid a recession in Taiwan this time, which would have been impossible for this export-oriented economy without policy responses. 

Most importantly, the fundamentals in Taiwan are relatively safe versus other emerging economies, in our view.  First, Taiwan does not face liquidity problems, and inflation is the lowest in the region.  Second, Taiwan will not face a sudden capital outflow, since there was no hot money inflow to being with.  As well, the Taiwanese have a substantial amount of overseas investment that can flow back to Taiwan.  Third, the country maintains a decent current account surplus, and the financial account swung back to a surplus this year after 10 quarters of deficits.  Coupled with the fifth-largest foreign reserves in the world, Taiwan does not face a dollar shortage resulting from this global liquidity crunch.  Last, but not least, there are no excesses in the domestic economy, and therefore, there is no need for any major correction.

In light of the coming export slump, we are revising down our 2008 GDP growth forecast for Taiwan to 4.2% from 4.8% and cutting our 2009 forecast to 3.4% from 5%.  The downside is concentrated in the export sector due to the very bearish outlook for global tech consumption.  Capex is also likely to drop, but at a much milder magnitude when compared with the 2001 recession, since capacity growth in this cycle is much more disciplined.  Consumption in Taiwan is already very sluggish, and further downside appears protected, as there was no income or wealth effect detected in consumption in this cycle. Therefore, the drop in export income and asset prices should have a much more muted impact on Taiwan’s consumption than on others in the region.  We expect the bottom of GDP growth to come in 1Q09, when negative sequential growth could be recorded.  Nevertheless, what could be interesting is that we are actually expecting a pick-up in nominal GDP growth next year due to an improvement in terms of trade, as import prices drop faster.

Export Contribution from Emerging Markets to Slow

The market has been negative about Taiwan’s export growth since the US subprime crisis broke out last year, given the common belief that the Taiwan export sector would be very sensitive to US demand.  We disagreed because we saw support for tech products from emerging markets.  Taiwan’s export growth did rise faster than expected in most of the year, but the tide has turned, since emerging market demand will come under pressure due to the wealth effect retreat and commodity price correction.

The structural problem within Taiwan’s export sector lies with the lack of industry diversification and limited brand recognition in the global market.  Its heavy reliance on high-tech products makes it most vulnerable to the coming severe downturn in global discretionary consumption.  We therefore expect Taiwan’s export growth to see the first contraction next year since the tech bubble burst in 2001.

Nevertheless, This Will Be Different from the 2001 Recession

Although we expect exports to plunge in the next two to three quarters, the impact on Taiwan’s domestic economy will be milder this time compared to 2001, when the export downturn dragged the whole economy into a recession.  The biggest difference in this cycle is that domestic facility investment has failed to grow together with the latest export boom due to production hollowing out and weak confidence.  In fact, facility investment disconnected and turned sharply negative last quarter despite exports continuing to grow – the peak of the current cycle’s facility investment growth was only 10% compared to 25% before the 2001 recession.  This early adjustment in facility investment and the relatively more disciplined facility investment versus export growth will be the key to helping Taiwan avoid a recession from capacity adjustment as in 2001.

The disconnect between exports and consumption is even bigger in this cycle, and apparently, the export boom has not translated into any consumption growth since the latter is more a confidence issue for political and structural reasons.  It is also obvious that the rally in asset markets last year and earlier this year was so short-lived that it did not result in any change in spending behavior, and therefore, no adjustment is needed now when wealth is retreating.  The Taiwanese are already under-consuming, so how much lower can consumption go?  In our view, this export-led downturn will not cause further severe deterioration in the domestic economy.

The correction in asset prices will usually cause a shrink in domestic demand through the wealth effect, and a weaker domestic economy will only cause asset prices to fall even further, i.e., turning into a vicious cycle and therefore a prolonged slowdown.  However, such wealth effect was not found in Taiwan to begin with, and therefore, we should not see a vicious cycle.  As a result, we expect the slowdown in Taiwan’s domestic economy to be milder and shorter than others in the region, but the magnitude of upside is again a function of its confidence level.

Strong Liquidity Provides the Best Cushion Now

Liquidity, when not used, cannot change the direction of growth, but having strong liquidity is definitely a plus to Taiwan now when the rest of the world is struggling with a credit crunch.  As of July 2008, the deposit money banks in Taiwan had liquid reserves of NT$5.6 trillion (US$180 billion). The abundant liquidity condition is also reflected in the little-changed interbank rates in Taiwan, with the latest three-week rate staying at 2.1%, which is about the same as a year ago.  Meanwhile, Taiwan does not face dollar shortage issues since it is stable, running a current account surplus projected to be 7.2% of GDP this year. Most important, its financial account swung back into surplus this year after running at a deficit every quarter since 3Q05.  This small economy also possesses the fifth-largest foreign reserves in the world, at US$281 billion, providing yet another cushion against this global liquidity crunch.  The strong savings accumulated in Taiwan over the last decade have now become the strongest weapon to fight against this global recession.

Policy Implications

We applaud the Taiwanese government’s proactive approach to tackling the country’s economic issues and for not letting itself fall behind the curve.  In our view, it has been on track with its policy agenda on cross-strait travel and transport arrangements, although more effort could be put into liberalizing capital flows between the Mainland and Taiwan.  Planning for infrastructure projects remains intact.  The currency has been kept relatively stable, which is key to containing inflation and to maintaining confidence in NTD assets.  The central bank (CBC) was one of the first in the region after China to respond to the US financial market turmoil by immediately lowering the reserve requirement ratio, which was followed by a surprise interest rate cut of 12.5bp in its recent 3Q monetary policy meeting.  We expect a further 75bp cut in the CBC rediscount rate before the end of 2009.  In fact, with the latest inflation data way below expectation (+3.1% in September versus +4.8% in August) and core inflation staying mild at a mere +1.6%, we see room for a more aggressive rate cut of 25bp in the 4Q meeting, and we do not rule out the possibility of policy moves before the meeting.

On the fiscal side, we expect the next big policy move to be tax rate cuts, likely before year-end.   The tax reforms are likely to be broad-based, from cutting the inheritance tax to corporate income tax to personal income tax.  The boost from a reduction in the inheritance tax will probably take longer to be reflected in the economy, but the impact from income tax rate cuts should be more imminent, and we hope the government will adopt a more ambitious approach.  The inheritance tax is expected to be cut to 10-20% from 50% and the corporate tax rate cut to 20% from 25%.  We do not have much detail on the changes in personal income tax, which we believe could provide upside surprise.  Taiwan’s fiscal account is still in deficit, although it narrowed to -0.6% of GDP in 2007 from an average of -2.3% during 2002-06.  Nevertheless, we do not expect this to be a constraint on expansionary policy since Taiwan’s government debt level is low.

The new administration in Taiwan has been in office for less than five months, but it has already gone all out tackling the economic challenges.  Unfortunately, domestic sentiment is still sluggish given the depressing global macro backdrop.  However, we believe that the absence of a major shock in the economy resulting from a lack of excesses, strong savings and strong liquidity, coupled with persistent supportive policy from the government, will help Taiwan recover from an export downturn in the next two quarters.