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Asia 2010 Outlook: update
Emerging Markets Asia Research
May 14, 2010
www.morganmarkets.comThe certifying analyst is indicated by an AC. See page 68 for analyst certificationand important legal and regulatory disclosures.
Overview: EM Asias leadership shifts from growth to policyMarkets and policymakers have consistently underestimated the strengthof the economic recovery in EM Asia. Just as the growth gap between theregion and developed markets widened, so too will the policy gap. A historicshift is occurring - EM Asia will lead, not lag, the global policy cycle.Leaders in growth, India and China will also lead the policy normalizationprocess, with the region drawing on a mix of administrative measures,traditional monetary tools, and FX appreciation.
FX: Anticipating CNY changeWith CNY appreciation expected soon, we stick with our theme of portfolioinflow and economic recovery being robust drivers of Asia FX strength.
These themes were laid out in the January 2010 outlook essay, Lesscarry, more recovery, where we flagged INR and KRW as our favoredlongs. Trading through the short-term pain, those currencies have beenamong the strongest in EM Asia. In view of persistent tensions in Europe,
we like being long Asia in the EUR crosses to retain our positioning forthe CNY and Asian revaluation play.
Rates: Flatter curves aheadIn Asia local rates, we invest along four themes:(1) we set the bar highbefore investing anywhere, as even after the recent bond rally, curves arepricing in more tightening than our own central bank forecasts; (2) Asiancentral banks will continue their piecemeal tightening, with the aim to
normalize policy rates away from emergency-low levels; (3) foreigninvestment into Asian local markets will be supportive for bond marketsthat are sufficiently open and easy to access; (4) Asian government bondsupply is on the decline. Trades we like include: pay 3m2y swaps in KRW,hold a 2/10s flattener in KRW, hold onto 20-year Indonesian government
bonds (FR52), extend from the 5year MGS sector into the 10year, keep a2/5s flattener in TWD swaps, stay with received HKD 1y1y swaps position,and stay long KTB-swap spreads.
Sovereign credit: outlook still positive despite risksEven amidst global sovereign credit concerns, Asia's fundamentals continueto improve. In addition to fundamentals, technicals should be favorable.
Sovereign financing needs in the region may be smaller than expected asrevenues strengthen and as stimulus packages wind down. Lower financingneeds mean less supply. In Indonesia we stay neutral as strongfundamentals are offset by concerns about the transition in the economicteam. In the Philippines, we upgraded our position to neutral on a strongBoP outlook and successful elections. We stay overweight Sri Lanka and
recommend buying protection in Vietnam.
Dave Fernandez AC
(65) 6882-2461
Jahangir Aziz(91-22) 6157-3385
Bert Gochet(852) 2800 8325
Matt Hildebrandt(65) 6882-2253
Yen Ping Ho(65) 6882-2216
Jiwon Lim(822) 758-5509
Grace Ng(852) 2800-7002
Sin Beng Ong(65) 6882-1623
Qian Wang(852) 2800-7009
Overview
FXOutlook
Rtes Outlook
Sovereign Outlook
Chin
Hong Kong Indi
Indonesi
Kore
lsi
Philippines
Singpore
Sri Lnk
Tiwn
Thilnd
Appendix Tbles
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Emerging Markets Asia ResearchJPMorgan Chase Bank
Dave Fernandez (65) 6882-2461
Matt Hildebrandt (65) 6882-2253Sin Beng Ong (65) 6882-1623
EM Asias leadership shiftsfrom growth to policy
GDP growth has surprised on the upside across EM Asia
as economies fire on all cylinders
EM Asia to lead the global tightening cycle, shedding its
historical label as a laggard
India and China take centerstage in terms of timing and
substance of tightening
Policy rates do not fully capture tightening as Asia FX
appreciation and administrative measure feature
prominently
Upside growth surprises in Asia continue
Markets have underestimated the strength of the recovery
in EM Asia. While J.P. Morgan has consistently maintained
above-consensus 2010 GDP forecasts, even our relatively
bullish expectations have proven too tame. Market fore-
casts have risen almost every month since hitting a trough
in early 2009. At the same time, J.P. Morgan has also raised
its forecasts. As a result, our forecast for 2010 EM Asia
GDP growth remains more than one percentage point above
the consensus view, meaning we still expect the recovery to
outpace market expectations.
While the markets forecasts for 2010 Asian growth havebeen too low, policymakers had been even lower. Similar to
private sector forecasts, policymakers from the region have
consistently underestimated the power of EM Asias cycli-
cal position. This largely reflects views on the US that have
proven too pessimistic, but policymakers have also mis-
judged the strength of their own regional momentum.
Singapore serves as a dramatic example. The official 2010
GDP forecast has risen from 3% to 5% to 7% to 9% over the
last six months. Though sovereign concerns and financial
market contagion to the region remain a risk, strong growth
in the region should continue. Consensus and official GDP
forecasts will continue to trend higher.
Manufacturing still key to regional cycle
What always seems to get misjudged is the violence of the
swings in Asias manufacturing sector. Though only
about a third of GDP in most EM Asian economies, manu-
facturing continues to dictate, indeed dominate, the direc-
tion and magnitude of regional growth. When DM econo-
mies fell into recession, manufacturing was the link to Asia
and key transmission mechanism to other parts of the
economy. Indeed, after falling modestly in mid-2008, manu-
-75
0
75
150
%3m/3m saar
EM Asia ex China and India: industrial production
Electronics
Non electronics
03 05 07 09
3
4
5
6
7
year-on-year
EM Asia ex China and India: 2010 GDP forecasts
2009 2010
JP Morgan
Consensus
-30
-20
-10
0
10
20
30
-15
-10
-5
0
5
10
15
%q/q saar, both scales
Em Asia ex China and India: real GDP and manufacturing
97 99 01 03 05 07 09
Manufacturing GDP
2010 GDP forecasts: JP Morgan vs. Consensus
JPM Consensus DifferenceAbove
consensus?
EM Asia 8.7 8.3 0.4 X
EM Asia ex CN, IN 6.8 5.6 1.2 X
China 10.8 10.3 0.5 X
Honk Kong 7.1 5.2 1.9 X
India 8.3 8.2 0.1 X
Indonesia 6.2 5.9 0.3 X
Korea 5.8 5.4 0.4 X
Malaysia 7.7 6.0 1.7 X
Philippines 4.5 3.9 0.6 X
Singapore 9.0 8.5 0.5 X
Taiwan 8.2 5.6 2.6 X
Thailand 7.3 4.9 2.4 X
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facturing fell an astonishing 21% (annualized) on average in
4Q08 and 1Q09. In contrast, services fell only 1.3% in 4Q08.
Since exiting recession in 2Q09, manufacturing growth
has been on a tear, growing an average of 22% during thelast three quarters of last year. The strong rebound in this
sector should not come as a surprise given the external sec-
tor should not come as a surprise given the external nature
of the recession and because of the traditionally high beta
tendency of this sector, but still, the magnitude of recovery
has been impressive. In this cycle, EM Asia aggregate IP
recovered much more quickly than in the past. For example,
whereas IP required almost three years to return to its pre-
recession peak after the recession in the early 2000s, recov-
ery took only 22 months following the recent downturn,
even once China is excluded. Less-volatile services have
also grown quickly, averaging 12% growth in each of the
last three quarters of 2009.
As a result of the manufacturing swing, EM Asias rebound
has been even more spectacular than its fall. After sharp
contractions in 4Q08 and 1Q09, EM Asia GDP roared back,
leading the global recovery in both timing and magnitude.
Recall, while DM was still contracting, EM Asia grew an
annualized 13% in 2Q09, its fastest pace of growth except
for the quarter following SARS. In 2H09, growth slowed
from its unsustainable 2Q pace as J.P. Morgan had forecast,
but it was stronger than expected, remaining above trend
through the end of 2009. Though only a few 1Q10 GDP and
April activity reports have been released, it is already clearthat EM Asias strong momentum clearly carried into 2010.
Inventories and leading indicators say lessspectacular growth ahead
Inventory dynamics are poorly understood but are impor-
tant in EM Asias manufacturing cycle. When global reces-
sion hit, businesses slashed bloated inventories. From a
growth accounting perspective, this inventory dynamic was
the single-biggest drag on Asian GDP early last year. After
several months of intense drawdown, firms began to moder-
ate their pace of destocking as levels became leaner and as
shipments began to pick up. It was the moderation in the
pace of drawdown, not inventory restocking, that led to the
surge in production in 2009. This has been particularly true
in electronics.
Restocking in 2010 should prevent inventories from
becoming a large and sustained drag to growth. Though
data from the GDP accounts is poor and only a few
countries provide reliable monthly manufacturing inventory
figures, data that is available shows inventory levels in the
region declining through the end of 2009. With the global
recovery becoming more entrenched, restocking appears to
have started early this year and will likely continue in
60
70
80
90
100
110
120
Number of months for production level to return to peak, monthly data, sa
EM Asia ex China and India: electronics production
5 10 15 20 25 30
Jan 08 toJul 09 cycle
Sep 00 to Dec 02 cycle
80
90
100
110
120
60
80
100
120
140
Index, 2005 = 100, sa, both scales
EM Asia: inventory levels
Korea
Taiwan
Japan
00 02 04 06 08 10
0.8
1.0
1.2
1.4
1.6
1.8
ratioKorea and Taiwan: overall and high tech inventory to shipment ratios
High tech
Overall
00 02 04 06 08 10
10-year averages
-15
-10
-5
0
5
10
%-pt contribution to annualized quarterly growth
EM Asia ex China and India: contributions to domestic demand
2005 2006 2007 2008 2009
Net exportsFinal domestic demand
Inventories and statistical discrepancy
JPMorgan Chase Bank
Matt Hildebrandt (65) 6882-2253
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Emerging Markets Asia Research
coming quarters. Note that key exporters - Japan, Korea,
and Taiwan - show manufacturing inventory levels still well
below pre-recession peaks. Relative to shipments,
inventories still look low. Indeed, the 10-year averages for
overall and high tech inventory to shipment ratios in Koreaand Taiwan are 1.06 and 1.12 compared to ratios of only 0.91
and 1.12 currently.
Going forward, inventories will play a diminished role in
the regional growth story in 2010. The huge drag, and
then boost, to regional growth from the inventory cycle has
largely played out. We expect a modest regional restocking
cycle to produce choppy and inconsistent contributions to
growth, in line with historical precedence during times of
global expansion.
Indeed, this message of a more modest manufacturing
contribution to growth is echoed by the JPMorgan tech
indicator. This composite of global, US, and regional
variables that have historically tracked tech production in
the Asia is still at a level consistent with fast IP growth, but
not the explosive growth of the recent past.
Baton passed from fiscal support
Speed and size of government responses to the crisis were
impressive. Prudent fiscal positions allowed EM Asian
governments to respond to the recession aggressively.
While private consumption in EM Asia (ex China and India)
was up only 0.1% and fixed investment contracted 6.3% in
2009, government spending surged 7.1%. This spending,along with weaker revenues, led to a nearly tripling of EM
Asias aggregate fiscal deficit (3.6% of GDP from only 1.3%
in 2008). In many countries, the indirect effects of stimulus
were actually much larger as benefits from subsidies to
businesses to keep workers employed and tax incentives to
boost consumer spending are difficult to measure.
Though an important anchor during the crisis, the direct
effect of government spending should not be overstated. EM
Asian governments began to increase spending in early
2008 when slowdown in G-7 economies bec
ame evident. Between 1Q08 and 4Q09, EM Asian (ex Chinaand India) government spending grew at a 5% to 10%
annualized pace each quarter, or about 8% on average. This
was nearly twice the average quarterly pace during the
previous two years. Nevertheless, the contribution to GDP
growth was not that large, as the share of government
spending relative to private domestic or external demand is
small. Thus, though stable and a smoothing force,
government spending, even during the height of the crisis,
-40
0
40
80
120
160
-30
-20
-10
0
10
20
3040
50
60
EM Asiatech IP versus JP Morgan tech indicator
%3m/3m, saar, both scales
Tech IP
Tech indicator
99 01 03 05 07 09
-6
-4
-2
0
2
4
6
% -pt contribution to annualized quarterly growth
EM Asia ex China and India: contributions to domestic demand
2005 2006 2007 2008 2009
Private consumptionGovernment consumption
Gross fixed capital formation
-10
-5
0
5
10
q/q, saar
EM Asia ex China/India: private and government consumption
2008 2009
Private consumptionGovernment consumption
2007
Pvt. Consumption expenditure (% q/q,saar)
% of
GDP, 07
Average*
(2005-2007)08Q3 08Q4 09Q1 09Q2 09Q3 09Q4
EM Asia 46.7 9.0 8.7*
EM Asia ex China 56.1 5.6 7.6 0.2 6.6 6.5 15.5 3.0EM Asia ex CN,IN 55.8 4.5 0.0 -6.7 -0.6 8.9 5.5 6.4
Philippines 77.4 5.4 8.6 2.2 -1.6 12.3 1.9 6.2
Hong Kong 60.2 5.8 -3.2 -8.1 -6.2 16.1 2.4 8.7
Indonesia 57.6 5.8 6.4 4.6 6.7 1.6 6.0 -0.9
India 57.2 8.8 6.3 3.5 3.4 -6.0 22.8 -3.9
Taiwan 54.6 2.2 -7.5 1.3 1.6 2.6 3.1 19.3
Korea 54.1 4.8 0.4 -16.8 1.1 14.1 7.1 1.6
Thailand 51.8 3.2 2.0 -0.7 -10.8 3.1 4.1 11.3
Malaysia 50.5 8.8 5.2 -5.6 -4.4 7.3 5.2 4.4
Singapore 39.0 4.7 -3.5 -10.3 -6.4 8.3 12.4 3.8
China 35.6 13.6 16.0*
*year on year growth
JPMorgan Chase Bank
Dave Fernandez (65) 6882-2461
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Emerging Markets Asia Research
never directly added more than one percentage point to
growth in a quarter.
Large fiscal payback not likely, sentiment impact may be
worth watching. Since the actual contribution to GDP fromgovernment spending was never that large, the winding
down of stimulus should not be as a big of a shock as some
fear. For starters, prudent fiscal positions prior to the crisis
and lack of automatic-stabilizers had left governments in the
region in a position to reduce deficits slowly. In 2010, J.P.
Morgan estimates the aggregate EM Asian deficit to be
around 2.5% of GDP, still twice the size of the deficit in 2008.
But the stimulus was never intended to be a panacea. The
goal was to provide a psychological boost to consumer and
business confidence and to help smooth over consumption
until private demand returned as an engine of growth.
Consumers are no longer holding back. After sequentialgrowth in private consumption either stalled or contracted
four straight quarters between 2Q08 and 1Q09, consumer
spending has rebounded strongly. Between 2Q09 and 4Q09,
private consumption expanded at roughly a 6.5% annualized
pace on average each quarter, the fastest average rate over
any three-quarter period since early 2000. Easier monetary
conditions, greater confidence, strong wealth effects, and
pent-up demand were all contributing factors. Recovery has
been so broad-based such that private consumption in
every EM Asian economy had recovered to pre-recession
level by the end of 2009. With labor market conditions
improving, debt levels generally low, and rises in interest
rates likely to be gradual, private consumption should
continue to expand at a healthy clip in coming quarters.
Fixed investment has picked up but still has much room to
run. Investment tends to be hardest hit during recessions in
EM Asia and the recent recession was no exception. Most
countries experienced a double-digit peak to trough decline
in investment, with Taiwan experiencing more than a quarter
decline. Investment has since rebounded, but compared to
private consumption, recovery has been modest. Only in
Korea has the level returned to its precession peak while
most others are not expected to do so until mid or late 2010.
Domestic demand is not the entire story
Exports have been robust. External demand has traditionally
been a driving factor in EM Asian growth and this recovery
has not been different. Exports surged in 2Q more than 30%
and grew more strongly than private consumption or fixed
investment in 2H09. Much of the demand has come from
regional sources, as well as other emerging markets, but
demand from G-3 has been strong too. Differentiating
between the sources of final demand is difficult given the
lack of detailed volume trade data and problem of double
counting nominal data. However, with emerging market and
EM Asia: present recession and recovery time
% GDP loss1
Recovery to
pre recessionpeak level
Forecasted/
Actualrecovery
period2
Qtr ofrecovery
3
Hong Kong -7.4 No 5 2Q10
Korea -4.6 Yes 3 3Q09
Malaysia -6.4 Yes 3 4Q09
Philippines -1.7 Yes 2 4Q09
Singapore -9.5 Yes 4 1Q10
Taiwan -9.8 Yes 3 4Q09
Thailand -7.1 No 4 1Q10
Current
EM Asia: private consumption
% Pvt.
consumption
loss1
Recovery to
pre recession
peak level
Forecasted/
Actual
recovery
period2
Qtr of
recovery3
Hong Kong -5.8 Yes 3 4Q09
Korea -4.6 Yes 3 3Q09
Malaysia -2.5 Yes 2 3Q09
Philippines na Yes na na
Singapore -5.1 Yes 3 4Q09
Taiwan -2.7 Yes 5 4Q09
Thailand -2.3 Yes 2 4Q09
Current
EM Asia: gross fixed investment
% capex loss1
Recovery to
pre recession
peak level
Forecasted/
Actual
recovery
period2
Qtr of
recovery3
Hong Kong -17.5 No 6 2Q10
Korea -6.3 Yes 3 4Q09
Malaysia -13.0 No 6 2Q10
Philippines -8.1 No 5 2Q10
Singapore -17.9 No 7 3Q10
Taiwan -26.8 No 7 4Q10
Thailand -17.3 No 7 4Q10
Current
1. Peak to trough decline in GDP/Pvt. Conspn/Capex, sa2. Quarters required for real GDP/Pvt. Conspn/Capex to recover to pre-recession level from trough
3. Quarter in which GDP/Pvt. Conspn/Capex recovers/expected to recover to pre recession peak
China and India excluded as they have expanded during these periods
JPMorgan Chase Bank
Matt Hildebrandt (65) 6882-2253
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Emerging Markets Asia ResearchJPMorgan Chase Bank
Dave Fernandez (65) 6882-2461
95
100
105
110
Index, 1Q2008=100, sa
Developed markets and EM Asia: real GDP
2008 2009 2010 2011
EM AsiaDM
US growth expected to be firm in coming quarters, exports
from the region should remain a support to growth.
Net exports may be more supportive in coming quarters.
During the crisis, the contribution to GDP growth from netexports surged as imports contracted faster than exports. In
subsequent quarters however the contribution was mostly
flat as gains in exports were offset by surging imports.
However, with production staying strong early this year and
the outlook for external demand still positive, net exports
contribution to growth may turn more supportive in 2010.
Trading places: EM Asia vs DM growth
Putting all of this growth analysis together, we believe that
Asia is positioned to continue to significantly outpace DM
growth. Indeed, one of the defining aspects of the global
upturn so far is the differential performance of EM Asia rela-tive to developed markets. Economic activity in EM Asia
returned quickly to pre-crisis levels, while the recovery in
DM started later and has been very gradual. More broadly,
this marks a departure from the historical experience when
DM demand led regional activity. In effect, the re-hitching
and re-arrangement of the regional demand locomotive
seems to have occurred in the past year.
In part, the differential performance between the two re-
gions reflects the relative health of balance sheets in both
the private and public sectors. Indeed, the net multiplier of
lower rates and expansionary fiscal policy tends to be more
effective when balance sheets are in good health and whenaggregate financial leverage is relatively modest. Specifi-
cally, the strength in EM Asia owes a large part to the two
largest economies in the region - India and China - and de-
velopments there will continue to act as a barometer for
near-term cyclical trends around the broader region.
A historic shift in global tightening cycle
This differential growth path between EM Asia and DM
thus frames the anticipated policy path of the regional cen-
tral banks. On our forecast, this will be first cycle in which
EM Asia will lead the global policy cycle, rather than lag.
Indeed, our forecast assumes that the bulk of the rate hikesaround the region will occur in 2010 even before the G-3
begin their cycle. There will be variations across the region
(see Shared macro dynamics, but varied policy responses,
Asia 2010 Outlook), but the main focal point for the region
will be India and China rather than on the US as in previous
cycles. This marks a sea change relative to history.
The expected policy tightening in EM Asia will echo certain
aspects from the previous cycle between 2004-2008. Al-
though regional rates are nominally higher than in devel-
oped markets, the rate cuts from peak to trough - 250bps -
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
%p.a., eop, both scales
Developed markets and EM Asia: policy rates
2008 2009 2010 2011
Developed markets
EM Asia
0
20
40
60
80
100
120
140
Basis pointsEM Asia: 2010 policy rate forecasts
IN PH MY KO TH TW ID
125
100 100
81
50 50 50
CN HK
US = 0
EM Asia: 2010 forecast policy rate movements
Current Total Expected change* First hike
India 5.25 125 75 Mar-06
Philippines 4.00 100 100 3Q10
Malaysia 2.50 100 50 Mar-06
China 5.31 81 81 2Q10
Korea 2.00 50 50 3Q10
Thailand 1.25 50 50 Jun-06
Taiwan 1.25 50 50 3Q10
Indonesia 6.50 0 0 1Q11
Hong Kong 0.50 0 0 2Q11
*Present to Dec 10
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matched the decline in DM policy rates. At face value, this
thus argues that a return in regional growth back to the pre-
vious trend should also be reflected in a normalization in
rates. That this is not so reflects the expected tightening
coming from FX appreciation, which is will complementpolicy rates in lifting overall monetary conditions.
Another important point is that although EM Asias tight-
ening will not lead to a substantial increase in real rates, this
masks the impact of other tightening measures. In this re-
gard, the tightening in the upcoming cycle, like the cycle in
2004-2008, will include stronger FX rates and should be re-
flected in a tightening in overall monetary conditions. Even
then, the need for significantly tighter monetary conditions
is expected to be checked by a relatively modest increase in
goods price inflation.
By contrast, some focus is expected to be directed towards
asset prices which have risen rapidly, especially in Greater
China. In an effort to contain these pressures, the policy
response has not relied on the traditional tools. Instead, this
current cycle has already seen a tightening in administrative
measures to prevent excessive speculation in asset markets.
This last feature is a relatively new dynamic compared to
previous cycles and suggests that monetary conditions
may not fully capture the underlying tightening in the sup-
ply of credit across the region, even as the cost of that
credit remains relatively low by historical standards.
Some echoes from the 2004-2008 cycleImportantly, despite our forecast is policy normalization in
Asia during 2010, no central bank is expected to move to a
tightening stance. For example, although India is expected
to raise its repo rate by 125bps through the rest of 2010, this
would only bring it to back to levels seen in 2006.
This is a dynamic similar to the 2004-2008 cycle. As a recap,
unlike pre-Asian crisis tightenings, the last cycle saw very
few central banks match the increase in Fed Funds rates, the
exception being Indonesia which experienced a mini bal-
ance of payments crisis in 2005 and also Hong Kong whose
peg limits its monetary flexibility. One key factor that permit-
ted a more modest tightening in rates was the appreciation
in regional currencies, with the July 2005 CNY revaluation a
hallmark of the shift in regional FX policy.
Similarly, the fairly modest forecast rise in regional policy
rates relative to the pre-crisis levels reflects a policy normal-
ization aimed at bringing them away from emergency set-
tings and back into a range more consistent with a regular
economic cycle. Moreover, this gradual normalization in
rates is expected to be complemented by stronger FX rates.
The expected CNY appreciation will, like in the previous
cycle, provide the impetus for a broader regional apprecia-
0
100
200
300
400
500
600
Basis points, trough to peak
Policy rate increases, 2004 - 08cycle
ID TH TW KR PHHK IN CN MY
US = 425
542
425375
300225 216
20080 75
EM Asia: exchange ratesLocal currency / USD
Latest Jun-10 Sep-10 Dec-10 % change1
MYR 3.21 3.15 3.10 3.02 6.29
INR 45.11 44.00 43.25 42.75 5.52
PHP 44.91 44.00 43.25 42.75 5.05
SGD 1.38 1.34 1.33 1.32 4.55
THB 32.29 32.00 31.50 31.00 4.16
KRW 1144 1120 1070 1100 4.00
CNY 6.83 6.80 6.70 6.60 3.43
TWD 31.68 31.50 31.25 30.75 3.02
IDR 9085 8800 8700 8900 2.08
HKD 7.78 7.8 7.8 7.80 -0.26
1. Percent appreciation, from latest to Dec 10
JPMorgan Chase Bank
Sin Beng Ong (65) 6882-1623
-3-2-101234567
% appreication, current to year end
EM Asia: 2010 FX forecasts
MY PH TH CN ID HKIN SG KR TW
EM Asia: monetary conditions indices
% deviation from long term average
Current 2Q11 Change
Interest rate Exchange rate
China 0.6 2.7 2.1 0.8 1.3
Hong Kong -4.0 -4.1 -0.1 0.3 -0.4
India -6.6 -3.3 3.3 2.6 0.7
Indonesia -13.9 -13.3 0.6 0.0 0.6
Korea -6.0 -6.0 0.1 0.2 -0.2
Malaysia -1.5 0.0 1.6 0.7 0.9
Philippines -6.3 -4.9 1.4 0.5 0.9
Taiwan -3.6 -2.6 1.0 0.3 0.8
Thailand -2.8 -1.5 1.3 0.3 1.0
Source of change
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tion. In this respect, monetary conditions provide a useful
indicator to determine the impact of the combined effect of
both rates and FX on the overall policy stance.
Decomposing the expected tighteningAlthough there are shortcomings in monetary condition
indices - including the relative weights allocated to FX and
rates - the indices nonetheless provide a useful framework
in terms of determining both the magnitude and sources of
expected monetary tightening.
The J.P. Morgan forecast assumes that India will see the
most tightening around the region as reflected in the MCIs
while China will see less though the sources of that tighten-
ing will be fairly different. In the case of India, the bulk of
the heavy lifting will done through interest rates, with
125bps expected in hikes from trough to end-2010 with lesscoming from FX. Although Chinas tightening is expected
to be one of the larger ones within the region, this is still
modest relative to the underlying vigor in the economy
which will also be complemented by tightening in adminis-
trative measures.
Indeed, Chinas tightening is expected to gradual and thus
should not derail the economy. Moreover, unlike India, an
even share of the normalization is expected to come from FX
rates and policy rates. In the case of Indonesia, although
the FX is expected to appreciate in 2010 amid no change in
rates, while in 1H11 the FX could reverse while rate hikes
begin. In Korea and Taiwan, the expected currency appre-ciation will mean that policy rates may not have to move as
much. In Hong Kong, the currency peg effectively con-
strains monetary policy flexibility. This constraint, amidst
differential growth rates between the US and Hong Kong,
suggests that the HKMA may have to rely on other tools.
Watch other prices, not goods prices
Moreover, the need for an aggressive tightening in mon-
etary conditions is mitigated by the expectation that infla-
tion will drift, not spike, higher in 2010 and then settle
around the historical trend by 2H11. This forecast for infla-
tion, even amidst economic vigor, suggests that there islittle need to move beyond gradual normalization.
The relatively benign forecast for inflation reflects two fac-
tors. The first is that commodity prices will not surge unlike
the episode in 2007/2008 and second, the modest increase in
commodity prices should be mitigated by the expected ap-
preciation in regional currencies. The energy forecast as-
sumes that crude oil will reach US$85/bbl. by 2Q11 from a
peak of US$94/bbl. in 3Q10 (third chart). However, in over-
year-ago terms, the peak of the price increase was in Febru-
ary this year which saw crude prices rise 95%oya with the
forecast trajectory looking for a gradual decline in over-year-ago terms to be effectively flat by 2Q11.
The interplay of these two dynamics should thus lead to a
rise in real rates, reflecting a moderation in inflation by 4Q10
and also an increase in nominal policy rates over the same
period. Indeed, at an aggregate level, real rates are expected
to increase by 1.0%pts through the end of 2010. Of that in-
crease, 0.5%pt. will come from a decline in oya inflation as
base effects wear off by 4Q10 and the other 0.5%pt. will be
from the nominal increase in policy rates (table).
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
% pt. contribtion to change in monetary conditions, 4Q10 less current
EM Asia: sources of tightening
IN CN PH TW HK
FX
Rates
MY TH KR ID
0
2
4
6
8
% oya
EM Asia: CPI
00 02 04 06 08 10
EM Asia
EM Asia ex China India
2000-2009 average
0
50
100
150
-100
-50
0
50
100
150
US$/bbll., WTI
Crude oil prices
%oya
00 02 04 06 08 10
LevelChange
JPMorgan Chase Bank
Dave Fernandez (65) 6882-2461
8/9/2019 JPM May 18 2010 Outlook
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Asia 2010 Outlook
May 14, 2010
Emerging Markets Asia Research
EM Asia: real policy rates
%p.a. and %oya for headline CPI
2Q10 3Q10 4Q10 Change1
EM Asia real rate 0.0 0.4 1.0 1.0
Nominal rate 4.3 4.5 4.7 0.5CPI 4.2 4.2 3.7 -0.6
China real rate 2.2 2.2 2.8 0.6
Nominal rate 5.6 5.9 6.1 0.5
CPI 3.4 3.7 3.3 -0.1
Hong Kong real rate -2.6 -2.8 -2.0 0.6
Nominal rate 0.5 0.5 0.5 0.0
CPI 3.1 3.3 2.5 -0.6
India real rate -4.2 -1.9 -0.7 3.5
Nominal rate 5.5 6.0 6.0 0.5
WPI 9.7 7.9 6.7 -3.0
Indonesia real rate 1.8 1.2 0.7 -1.1
Nominal rate 6.5 6.5 6.5 0.0
CPI 4.7 5.4 5.8 1.1
Korea real rate -1.0 -1.1 -0.7 0.3Nominal rate 2.0 2.3 2.5 0.5
CPI 3.0 3.3 3.2 0.2
Malaysia real rate -0.6 -0.8 -0.3 0.3
Nominal rate 2.5 3.0 3.0 0.5
CPI 3.1 3.8 3.3 0.2
Philippines real rate -1.1 -1.0 0.7 1.8
Nominal rate 4.3 4.8 5.0 0.8
CPI 5.3 5.7 4.3 -1.0
Taiwan real rate -1.1 -0.4 -0.2 0.9
Nominal rate 1.3 1.5 1.8 0.5
CPI 2.3 1.9 1.9 -0.4
Thailand real rate -2.8 -1.5 0.1 2.9
Nominal rate 1.5 1.8 1.8 0.3
CPI 4.3 3.2 1.7 -2.61 Dec 10 less Jun 10, eop
60
80
100
120
140
160
Index, 2000=100, nsa
Hong Kong: CPI and real estate prices
00 02 04 06 08 10
CPI
Real estate
Although goods price inflation is expected to be modest
over the next year, the same cannot be said for real estate
prices. One striking development, best reflected in Hong
Kongs experience, is the rapid increase in real estate prices
in the past year, with property prices up 35% between 4Q08and 1Q10 even as inflation rose a more modest 2% over the
same period (chart). Also of note is the contrast relative to
the previous recession. In the tech recession of 2000, prop-
erty prices in Hong Kong took around five years to recover
to the peak levels seen in 1Q00. By contrast, in the recent
recovery, property prices are now well above the pre-crisis
peak, effectively only taking only six months to recover
back to the pre-recession peak.
While the rapid recovery to an extent mirrors the recovery in
the real sector, part of the fuel for the recovery can also at-
tributed to the pegged exchange rate system which effec-
tively ties interest rates in Hong Kong to the US even as
their growth trajectories deviate. The Hong Kong example
highlights the challenges faced by central banks and also
provides some insight into the nature of policy tightening
over the next year.
Administrative not market tightening in
credit supply
Even though goods price inflation is not expected to rise
significantly, which thus reduces the need for a significant
tightening, the recent upturn in asset prices especially in
Greater China is causing concern among the monetary au-
thorities. Ostensibly, traditional policy tools, such as higher
rates, would help slow the increase in asset prices but this
could have two unwanted side effects. The first is that it
could derail the incipient recovery in the real sector and sec-
ondly, rising rate differentials with the Developed Markets
could increase inflows into the region and thus add to do-
mestic liquidity.
These considerations thus make administrative controls on
real estate attractive relative to the other available tools.
However, by its nature it is hard to track the impact of such
controls through the traditional market measures of mon-
etary policy which would include the price of credit andoverall liquidity conditions reflected in the money supply
indicators.
Given these constraints, the evolution of credit and asset
prices should be a key focus for central banks. Aside from
real estate prices, another useful proxy indicator would be
the increase in credit from sectors associated with private
real estate.
JPMorgan Chase Bank
Sin Beng Ong (65) 6882-1623
8/9/2019 JPM May 18 2010 Outlook
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Asia 2010 Outlook
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Emerging Markets Asia ResearchJPMorgan Chase Bank
Yen Ping Ho (65) 6882-2216
FX: Anticipating CNY change
CNY to underpin the Asian appreciation theme
Sovereign risks in Europe could play out as a destructive
or supportive force
We favor short EUR/Asia into 2H10
With CNY appreciation expected soon, we are happy to
stick with our theme of portfolio inflow and economic re-
covery being robust drivers of Asian currency strength.
These themes were laid out in the January 2010 outlook es-
say, Less carry, more recovery. So far, it has played out
well as we head towards the halfway point of 2010. Capital
inflows to EM Asia have been strong, driven by global EMfund inflows and passive buying in the region, while GDP
strenghth has been underscored by upward forecast revi-
sions. In our January report, we flagged INR and KRW as
our favored longs. Trading through the short-term pain, INR
and KRW have indeed emerged as the 2nd and 3rd stron-
gest currencies in EM Asia.
Two core themes will guide the appreciation path into 2H
2010: 1) An expected move on CNY is a strong underlying
support for the region; 2) We watch sovereign risks in
Greece and Europe which could play out either as a destruc-
tive or supportive force.
(1) CNY revaluation:The prospect of a CNY realignment
has been a cornerstone to our Asian appreciation theme.
Central banks in the region, concerned about exchange rate
competitiveness against China, have moved aggressively
on FX intervention to ease valuation strains versus CNY.
J.P. Morgan expects China to move on the currency some-
time between May and July. The economic case for a move
has been in place for some time and implementation is a po-
litical call, in our view. With the US Treasury having de-
layed the FX manipulation report, policymakers in China
have a window of opportunity to move before the political
rhetoric steps up again into US mid-term elections later thisyear.
We view the current CNY regime as providing sufficient
flexibility to allow CNY appreciation without a big bang
change. The authorities will likely guide the daily fixings
lower, while allowing market forces to push spot down
within the existing band. We are forecasting USD/CNY at
6.50 year-end, though even that mild call may be too aggres-
sive, especially should China further delay the start of the
adjustment.We are not expecting a one-off move. However,
the band could be widened, adding some flexibility to
Chinas currency regime.
-8%
-6%
-4%
-2%
0%
2%
4%
MYR KRW INR IDR PHP THB SGD TWD CNY HKD JPY
Local FX appreciationagainst USD in the 1st
4M of 2010
change in spot from year-to-date, %
KRW and INR among the leaders prior to the Greece-related unwind
(2) Sovereign stress: While fiscal fears in Europe have not
translated into fundamentals strains for EM Asia, we are
wary of contagion risks. Markets have so far been comfort-
able ring fencing Asian fundamentals out of the European-
bloc, but risks remain that investor pain, in the event of a
systemic unwind, may translate into general deleveraging
irrespective of geography and fundamentals.
The extent to which European stress can be ring fenced
within the Union is unclear and still clouds the outlook for
Asia FX. The latest support package should help backstopcontagion risks, but should EU sovereign stress morph into
an economic and financial shock that is global in scale, the
disruption to global capital flow would translate into a sud-
den stop for EM Asia and even systemic unwind. However,
should markets view this only as a Europe-specific event,
then fundamentals in Asia could place the region as the
destination for global easy-for-long liquidity. The balance
of views is not expected to skew decidedly to either side
soon, as the European story is still unfolding. Expect Asia
appreciation to be volatile with bumps along the way.
Equity inflow to Asia a driving theme
Net foreign equity flows (USD billion)
Apr Mar Feb Jan Dec
Korea 4.62 4.69 0.00 0.56 1.94Taiwan 3.69 3.55 -2.80 0.04 3.05
Thailand -0.13 1.37 0.16 -0.23 -0.14
Philippines 0.20 0.04 0.06 0.05 0.03
Indonesia 0.17 0.54 -0.21 0.05 0.41
India 2.79 6.48 0.95 1.86 0.92
Total 11.34 16.67 6.21 3.39 3.85
Sources: JPMorgan, Bloomberg, official figures
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Asia 2010 Outlook
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Emerging Markets Asia Research
Rates: Flatter curves ahead
Hard to pay rates even at these low levels as curves arepricing in more tightening than our forecasts, except inKorea
Foriegn investment into Asian local bonds will accelerateonce the European crisis winds down
Overall Asian bond supply is on the decline this year after
a record 2009
Most trades we like involve flatter curves
We take a view that contagion from the European sovereign
crisis to EM Asia through fundamental channels is limited.
After all, Asias trade and banking links with Southern Eu-rope are tiny. In addition, this weeks European shock-and-
awe package has greatly reduced the systemic risk in the
global banking sector, in our view. Having said that, there
are channels through which Asian local markets will see the
impact of Europes fiscal woes. We cite two: (1) investors
will continue to shift their assets out of indebted G7 coun-
tries and into EM (Asia) including local bonds, and (2) Eu-
rope will be exporting CPI deflation around the world, also
keeping Asian CPIs in check for longer than we thought.
With that in mind, the following are themes that guide our
investment decisions in the Asian local rates space for the
next 3-6 months:
Theme 1: Before we pay rates anywhere in our Asian rates
portfolio, we set the bar high. We do this because forwards
are still, even after the recent rally, pricing in quite a bit of
tightening compared to our own central bank forecasts. As
a rule of thumb therefore, we will only pay rates where (a)
central bank action is pretty imminent, and (b) negative
carry of the short position is not overwhelmingly negative.
As a consequence, we choose to be underweight/paid in
only one country at this time: Korea.
Theme 2: Asian central banks will continue their piece-
meal tightening. Despite the European sovereign debt cri-
sis, we see Asian central banks continue their stop-and-gopolicy rate tightening in 2Q and 3Q. Most of the tightening
is not in response to CPI inflation, but rather a move away
from ultra-low policy rate levels that are not appropriate
anymore in the upswing.
Theme 3: Foreign inflows will continue to support bond
markets that are easy to access from abroad. Partly, these
inflows are structural: real money managers record inflows
into EM bond funds this year, and central banks are diversi-
fying into EM as well. Partly, these inflows are more fickle
investments seeking short-term FX gain. The bond markets
JPMorgan Chase Bank
Bert Gochet (852) 2800-8325
that will continue to benefit the most from inflows this year
will be Malaysia, Indonesia, Korea, Singapore, and Thai-
land.
Theme 4: Bond demand this year will overwhelm supply.Asian governments are withdrawing fiscal stimuli, therefore
issuance calendars look very manageable this year. Domes-
tic real money investors are buying bonds in response to
weak stock markets. Foreign investors are diversifying into
local EM bonds. It therefore comes as no surprise that 1Q
has seen quite a bit of front loading of issuance. A possible
exception to this is India, where Gov-Sec issuance is at new
highs, and where foreign investment is limited in any case.
Recommendations
1. Paid/underweight in countries where Central Bank ac-
tion is mispriced
Korea: We pay outright in 3m2year swap. Underweight
KTBs in Asian portfolio.Korea is the only market in Asia
where we feel strongly about paying, as too little policy
tightening is priced in at the moment. While the majority of
investors believe that BoK will not tighten until year end
because it faces political headwinds and/or because CPI is
not threatening, we respectfully disagree. We think BoK
hikes in 3Q -perhaps even in July- despite the political
headwinds it faces. We base ourselves on discussions with
and the public statements of MoSF officials, whose tone
that was originally critical of rate hikes has changed in the
last few weeks. MoSF officials appear increasingly agree-able to tightening. We would rather pay 3m2y swap than 2y
spot swap as before long the 3m CD swap fixing will start
rising.
2. Outright long the long end of the bond curves where in-
flow vs supply conditions are attractive
Indonesia: Be long the 20-year sector outright. The combi-
nation of strong Asian growth and sluggish G3 economies
should keep global investors buying high-yielding, risky
assets in Asia. We think of this as the goldilocks global
-1000
-500
0
500
1000
Apr-04 Oct-05 Apr-07 Oct-08 Apr-10
Hard currency
Local currency
USD million / week
Despite European worries, inflows into EM retail bond funds have reach
new highs
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Emerging Markets Asia ResearchJPMorgan Chase Bank
Bert Gochet (852) 2800-8325
economy for Indonesian bonds. The DMO has already
filled 50% of this years domestic bond funding needs, and
we are only in May. Authorities can therefore be satisfied
with their year-to-date funding, and feel that they are close
to being done for the year. An additional reason for own-ing Indonesian bonds is that we expect no BI tightening
this year, as we believe that the BoP will remain in surplus
and inflation to remain under control and with in the target
band. Only in early 2011 do we see 50bp of rate hikes.
Malaysia: Extend from 5-year MGS into the 10-year sector.
In 1Q10, the Malaysian bond market rallied and made up
what it lost last year, especially in the 5year sector. This
year, MGS demand from abroad and from domestic real
money investors is strong. Add to that an issuance plan
that is 30% smaller than last year. So, despite Bank Negara
being on a tightening path of 100bp towards an OPR of 3%
by year end, we feel comfortable owning 10year bonds at
4.10%.
3. Curves will flatten
Taiwan: Stay with the 2/5s flattener in swaps. Taiwan
stocks will probably struggle from Chinas various tighten-
ing measures, and therefore we think the long end of the
Taiwan curve will be capped. Meanwhile, the short end of
the curve underestimates the possibility of CBC tightening
in advance of a Fed move. Especially when China starts its
policy tightening cycle, the market will also expect Taiwan
to move as well (be it very gradually). This is not priced inand therefore we like to stay with the flattener.
Korea: Add a 2/10s KRW swap curve flattener, or pay
2year swap vs own 10year KTB. Overweight KTBs in Asian
portfolio. A weak Kospi in the face of regional policy tight-
ening, together with foreign investment in Korean bonds
will keep KTBs bid throughout the year. But the short end
of the yield curves price in little, if any, BoK tightening until
the end of the year. This is where the bond and swap
curves are vulnerable. We predict higher rates at the short
end of the curve as we think BoK will start tightening in 3Q.
4. Be long carry trades where we expect a status quo incurves:
Hong Kong: Receive the 3y-5y area. Hong Kong is the ulti-
mate carry curve, and will retain that crown as long as G7
countries cannot exit their funk. With Europe injecting li-
quidity again into the banking system, and probably the
Fed on hold longer than consensus expects, the HKD curve
remains a good receive in the 3y-5y area. And if ever US
Libors or the USD swap curve rise, then Hibors will lag and
the HKD/USD spread will widen, thereby keeping the HKD
curve still rather stable.
5. Be long swap spreads where inflows will richen bonds vs
OTC
Korea: Buy 5year KTB, versus pay 5y swap. Asian swap
spreads have become increasingly correlated with curren-
cies. The reason? As more foreign investors buy local
bonds for FX gain, the additional demand for bonds makes
cash product a relative outperformer versus OTC. The chart
shows how KTB swap spreads have moved in lockstep with
the currency over the past year. As we are constructive on
the Korean won, we are also constructive on swap spreads.
There are other countries where we see this same dynamic
as well, but we like Korea the best as swap spreads there are
still inverted, ie. bond yield below swap rate. The 5year
sector has the best carry and roll up the swap spreadcurve and this is also the area where bonds will suffer most
from supply worries.
-120
-100
-80
-60
-40
-20
0
20
Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10
110011501200
12501300135014001450150015501600
3y KTB - IRS (LHS)
USD/KRW (RHS)
bpKorea: Correlation between swap spreads and the currency
50
70
90
110
130
150
Jan-10 Feb-10 Mar-10 Apr-10 May-10
India 2s5s
Taiwan 2s5s
Malaysia 2s5s
bp
Asian curves flattened this year
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Emerging Markets Asia ResearchJPMorgan Chase Bank
Matt Hildebrandt (65) 6882-2253
Sovereign credit: outlook stillpositive despite risks
EM Asia has proven resilient and strong growth is expectedto continue despite global risks. Asia has rebounded from
the global crisis much more quickly and with much greater
vigor than previous recessions. While China and India have
led the region, growth across EM Asia has been strong.
Final private domestic demand is expanding robustly while
external demand from emerging and G- 7 markets is also sup-
porting growth. Improving labor market conditions, easy
monetary policy stances, positive wealth effects, and
greater confidence should support further broadening of
recovery to services from manufacturing. This also should
allow private sector demand to pick up some of the slack
from fiscal stimulus and inventories that will likely become
less supportive. We do not expect risks emanating from Eu-
rope to derail Asias economic outlook, though growth will
likely moderate toward trend from its robust pace recently.
Sovereign credit fundamentals to strengthen in 2H10.
Asian economic fundamentals and political structures were
not adversely affected by the recession. Strong economic
growth should allow governments to reduce budget deficits
(due both to greater revenues and less need for spending),
which will lead to lower domestic and external debt ratios.
Continued current account surpluses in most countries and
capital inflows to region should lead to higher fx reserve
levels. And with Sri Lanka and the Philippines having suc-cessfully held elections already, the political calendar is
quiet the rest of the year. The next scheduled political event
will be the 11th National Congress in Vietnam in early 2011.
Despite strong growth and credit fundamentals, upgrades
will be spaced out and slow, only Vietnam will likely be
downgraded. In 1998 and 1999, EM Asia experienced 8 up-
grades (following the 37 downgrades previously) while in
2003 the region received 7 upgrades after 5 downgrades.
Given the lack of ratings downgrades during the recent re-
cession, we have had fewer upgrades. We think further up-
grades will take time, even for countries like Indonesia, than
the market expects. Further upgrades in most countries willrequire structural reforms, which take longer to implement.
Vietnam is the only country where downgrades are likely,
given the countrys twin deficits, high inflation, low reserve
levels, and lack of transparency and reliable data.
Technicals to remain favorable. In addition to fundamen-
tals, technicals should be favorable. Sovereign financing
needs in the region may be smaller than expected as rev-
enues strengthen and as stimulus packages wind down.
Lower financing needs mean less supply. Malaysia and Sri
Lanka may come to market this year, along with the regions
larger habitual issuers Indonesia, Korea, and the Philip-
pines but issuance should deceline from 2009.
EM Asia EMBIG spreads to tighten by year end. EM Asia
sovereign debt performed well in 2009. Spreads tightened
390bp to 206bp at year end, comparing favorably to theEMBIG spread of 294bp. EM Asia spreads have tightened
further in 2010 to 191bp amid a lot of volatilty, and we ex-
pect spreads to tighten further. EMBIG spreads are forecast
to narrow to 225bp to 250bp from 292bp currently by year-
end and EM Asia is forecast to tighten to 160bp to 175bp.
Trade strategy and recommendations
We like Asian sovereign credit though we expect bouts of
contagion-related volatility from other parts of the world.
Thus, we recommend staying long Indonesia and Philip-
pines bonds due to positive fundamentals and technicals
while we are sellers of Vietnam. For CDS, sell protection onstrong credits after market flare-ups and buy it after periods
of spread tightening in anticipation of occassional volatility.
Indonesia: Stay neutral as Indonesias strong economic fun-
damentals are offset by concerns about Sri Mulyanis deci-
sion to step down as Finance Minister and due to crowded
positioning. We recommend holding bonds due in 2020 or
at the long end due to greater liquidity.
Philippines: We recently moved to neutral from under-
weight on successful completion of elections and a strong
BoP outlook. Moreover, positioning by local and foreign
investors is light. We recommend the bonds due in 2020 orat the long end of the curve due to liquidity considerations.
Sri Lanka: Stay overweight. Sri Lanka is on a positive track
with the end of civil war and a peaceful election earlier this
year. We recommend buying Sri Lankan 15s.
Vietnam: Sell bonds due in 2016 or 2020 or buy protection
on 5-year CDS after periods of market tightening (spreads
below 230bp) because of weak credit fundamentals. We
think further devaluation and a credit downgrade are likely.
EM Asia: sovereign issuance forecasts 2010
US$, mn Completed Remaining Total 2010F
EM Asia 3500 5750 9250
China
India
Indonesia 1500 1500 3000
Korea 1000 1000
Malaysia 1500 1500
Pakistan
Philippines 1000 1000 2000
Sri Lanka 750 750
Thailand
Vietnam 1000 1000
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Emerging Markets Asia ResearchJPMorgan Chase Bank
Qian Wang (852) 2800-7009
[email protected] Ng (852) [email protected]
6
8
10
12
14
16
0
5
10
15
20
%oya
China: real GDP growth
%q/q, saar
2004 2005 2006 2007 2008 2009 2010
%oya
%q/q, saar
-10
0
10
20
30
40
50
US$ bn
Merchandise trade balance
03 04 05 06 07 08 09 10
Nsa
Sa
China: economic indicators
Average
2003-07 2008 2009 2010f 2011f
Real GDP, % change 11.6 9.6 8.7 10.8 9.4Consumption* 2.4 4.3 4.4 4.6 4.7
Investment* 6.7 4.7 8.1 5.3 4.5
Net trade* 2.6 0.6 -3.9 0.8 0.3
Consumer prices, %oya 2.6 5.9 -0.7 3.2 2.5
% Dec/Dec 3.3 1.2 1.9 2.7 2.8
Government balance, % of GDP -0.9 -0.4 -3.3 -2.1 -1.8
Exchange rate, units/$, eop 7.92 6.82 6.83 6.50 6.20
Merchandise trade balance ($ bil.) 154.2 323.7 258.0 216.6 211.4
Exports 796.8 1423.4 1183.7 1499.7 1734.3
Imports 642.6 1099.7 925.7 1283.1 1522.9
Current account balance 180.1 404.9 307.7 270.3 263.2
% of GDP 7.4 9.4 6.3 4.6 3.8
International reserves, ($ bil.) 891.1 1948.1 2416.0 2766.0 3146.0
otal external debt, ($ bil.) 287.3 374.7 399.8 413.8 430.8
Short term 109.5 148.0 169.0 187.0 207.0otal external debt, % of GDP 11 9 8 7 6
otal external debt, % of exports 28 22 26 22 20
Interest payments, % of exports 1 1 1 1 1
* Contribution to growth of GDP.
Debt with original maturity of less than one year.
Exports of goods, services, and net transfers.
China
Solid growth trajectory in coming quarters, drivers of
growth broadening to private sectors of the economy
Inflation to average at a moderate 3.2% this year; nearterm focus on asset inflation risks
Near-term window of opportunity to kick start resumption
of gradaul CNY appreciation, increasing two-way volatility
Economy to become less credit-intenstive this year; fiscal
policy will still support growth
Since the beginning of the year, J.P. Morgan has upgraded
our 2010 GDP forecast for China to 10.8% from 9.7% previ-
ously. Our themes of broadening sources of growth, improv-
ing labor markets, and steady expansion private investment(including real estate) remain intact. Meanwhile, public in-
vestment stimulus will not retreat, though its pace of growth
will level off. The latest series of policy moves, including the
three 50bp RRR hikes, curbs on excessive credit growth, and
tightening on the housing sector, reinforce our call for cool-
ing FAI growth.
Though growth has surprised on the upside early this year,
we still expect a moderation in headline GDP growth to a
more sustainable 9%-9.5% sequential pace, starting in the
current quarter. On monetary policy, we expect the PBoC will
raise policy rates three times, by 27bp each, starting as early
as this quarter. On the currency, we believe recent Sino-US
political developments have opened a near-term window of
opportunity for Chinese policymakers to kick-start the re-
sumption of gradual CNY appreciation, possibly during the
May/June period, as exports recover.
2010 trade balance still in surplus
The most noteworthy development on Chinas external ac-
counts since the start of the year was the March trade deficit.
We note that Chinas exports had declined notably since
2H08, with net exports subtracting 3.9% from headline GDP
growth in 2009. With this trend in mind, the March trade bal-
ance slipped into deficit for the first time since April 2004,amid heightened concerns about potential near-term changes
to CNY policy. In our view, the March deficit was temporary
and the swing back into surplus in April is obviously consis-
tent with our view. The structural factors behind Chinas trade
surplus remain intact. Exports should be supported by the
steady global economic recovery, while imports of raw materi-
als/commodities will ease somewhat as we expect Chinas fixed
investment growth to moderate this year. On net, we expect
China to run a trade surplus of about US$100 billion in 2010.
Taking account of invisibles, the current account balance
should continue to move down, but stay in sizable surplus.
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-40
-20
0
20
40
-20
-15
-10
-5
0
5
10
%oya, both scales
Chinese exports and global IP
03 04 05 06 07 08 09 10
Chinese exports
Global IP
J.P. Morgan
forecast
10
20
30
40
50
60
%oya, 3mma
China: public and private sector FAI
2006 2007 2008 2009 2010
Public
sector FAIPrivatesector FAI
-50
0
50
100
2006 2007 2008 2009 2010
0
10
20
30
40
China: ongoing and new fixed investment projects
%oya, ytd, both scales
Ongoing projects
New projects
China: nominal fixed asset investment
2009 1H09 3Q09 4Q09 1Q10%share %oya %oya %oya %oya
Total 100.0 33.6 32.9 26.2 26.4
Primary industry 1.7 68.9 37.4 38.4 9.7
Textile and related 2.0 11.2 15.5 28.3 21.0
Machinery and electronic equipment 7.4 34.4 29.0 35.0 27.9
Metal and commodities 11.5 27.9 17.8 17.7 39.5
Transportation equipment 2.6 36.7 37.5 18.0 17.3
Electricity, gas, and water production 6.9 28.7 25.4 31.3 9.7
Housing 22.2 15.3 33.9 22.0 36.2
Transport infrastructure and construction 13.0 63.4 51.2 36.3 27.0
Water conservat ion, environment management 9.2 54.5 46.2 34.6 24.5
Healthcare, socia l securi ty, education, cul ture 4.2 55.3 55.6 28.6 26.01. Sectors targeted for expansion by the government.
JPMorgan Chase Bank
Qian Wang (852) 2800-7009
[email protected] Ng (852) [email protected]
Fixed asset investment growth moderates
One of the major features of Chinas growth this year is the
declining dependence on public sector and credit-intensive
investment. We expect the pace of fixed investment growththe crucial support of headline GDP growth last yearto
moderate to 22.5% this year from 31%. This is consistent
with FAI, in volume terms, rising but at only half the 36.5%
pace last year. The breakdown of recent investment data
shows a clear trend of moderation in public investment
growth. The central government has repeatedly reaffirmed
that it will maintain its stimulative fiscal policy stance, im-
plying continued fiscal spending to complete ongoing
projects. But, given rising concerns about overcapacity,
inefficient spending, and local governments financing con-
ditions, the central government has strengthened its control
over the approval of new local government investment
projects since late last year. Details on fixed investment byindustry show steady moderation in infrastructure-related
fixed asset investment (FAI).
Meanwhile, private sector FAI, which had underperformed
total FAI since late 2008, has been holding up well in recent
months. With growing signs of improvement in external de-
mand and export orders, export-related FAI growth, includ-
ing machinery and electronic equipment and textiles and
related industries, has largely held firm. In addition, while
real estate FAI growth moderated in late 2009, the pace of
expansion has picked up again. Given the latest round of
policy tightening targeting the property sector, however,
transaction volume has declined recently, with prices stabi-lizing, which would likely cause real estate developers to be
more cautious in investing. In contrast, as the government
pledges to increase the supply of low-income housing, total
real estate investment will likely rise steadily this year.
Looking further at the property market, the central banks
move to remove excess liquidity from the financial system
should help ease the monetary support that has been fan-
ning the property boom since early 2009. Indeed, during the
monetary normalization process playing out this year, we
expect the most credit-sensitive sectors to be most affected,
especially domestic asset markets, such as property.
Overall, supply and demand factors in the housing market
are gradually adjusting. On the supply side, new building
starts and real estate investment slowed sharply during
2H08 and early last year, on the back of earlier credit tight-
ening in 2007 and 1H08, although they have picked up
sharply since 2H09. Indeed, with rising property sales and
improving credit conditions last year, new building starts
for the 12 months ending March were 40% higher than the
average in the previous three years; these properties should
come on to the market by 2H10. On the demand
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10
20
30
40
50
60
14
16
18
20
%oya
Mortgage loans and loans to property developers
% share
2006 2007 2008 2009 2010
Loans to
property developers
Mortgage
loans
Real estate-related loans
as share of total loans
-50
-25
0
25
50
2006 2007 2008 2009 2010
0
10
20
30
40
China: real estate investment and domestic spot steel price
%oya
Real estateinvestment
Spot steel price
(two-month lag)
%oya, 3mma
JPMorgan Chase Bank
Qian Wang (852) 2800-7009
[email protected] Ng (852) [email protected]
side,through new, tighter mortgage rules, the authorities want
to rein in speculative/investment demand for property. Indeed,
the authorities intention to focus on mortgages is under-
standable, as mortgage loans leapt 53.4%oya in the 12 months
through March, a much faster pace than the loan extension toproperty developers. Meanwhile, looking at the broader pic-
ture of the banking sectors direct exposure to the property
market, real estate-related loans rose to 19.2% of overall bank
loans, the highest level in recent years.
Spotlight on local government finances
For major public investment projects in China, the common
practice has been for the central government, local govern-
ments, and commercial banks to each provide about one-third
of the total funding. As such, while the 2009 consolidated fis-
cal deficit was maintained at a moderate 2.2% of GDP, financ-
ing conditions at the local governments have increasingly be-come a concern. In particular, given the asymmetric fiscal rev-
enue-expenditure splits between the central and local govern-
ments (see box), revenue-short local governments have been
borrowing heavily from commercial banks, through companies
they own, to fund investment projects, and have provided
implicit guarantees for the repayment of these loans.
With the overall economic recovery, the central government
has increasingly focused on the rapid rise in these implicit lo-
cal government debts, and their potential impact on commer-
cial banks asset quality. Consequently, the approval process
for new local government investment projects has been tight-
ened notably since late 2009. There have also been sugges-tions to allow local governments to begin to issue debt di-
rectly, which should improve the transparency of their financ-
ing conditions. Total central government debt remains mod-
est, at about 19% of GDP by end-2009. Meanwhile, it is esti-
mated that total outstanding debt of local government-owned
companies has likely reached 6 trillion yuan (80% in the form
of bank loans), or nearly 18% of GDP. Combining these mea-
sures, the aggregate level of government debt, at less than
40% of GDP, is still moderate compared to most other major
economies.
Consumption to pick up broadlyVarious fiscal support measures, especially with regard to the
auto industry and rural households purchase of electronic
appliances, have helped to ensure that Chinas retail sales
held up solidly through the global downturn last year. Look-
ing ahead, increasing confidence in the economic recovery,
improving labor markets and hence household income will
support household spending in 2010.
The rebound in the export sector would help steady recovery
in labor markets and household consumption. The sharp
Chinas local government debt
Chinas current tax system channels a large portion of rev-
enue to the central government, while local governments are
responsible for most of the spending. In 2009, 53% of gov-ernment revenue went to the central government, but 80%
of the spending was conducted by local governments. Al-
though the central government will return part of the rev-
enue to local governments, most local governments rely on
non-budget revenue, such as land sales, to fund spending
(hence the natural tendency for local governments to sup-
port land and property prices).
As Chinas municipal bond market is still immature, it is the
general practice for local governments to borrow from com-
mercial banks through companies they own to fund invest-
ment projects, since the law prohibits local governmentsfrom borrowing directly from banks. For those loans, either
the future revenue from those projects or land will be used
as collateral, and local governments provide implicit guaran-
tees for the repayment of these loans. Along with the imple-
mentation of the 4 trillion yuan fiscal stimulus package,
such implicit government debt has risen rapidly, even
though the part of local government funding for the stimu-
lus package had lagged last years schedule. Looking
ahead, the central government will likely increase its share
of funding for the stimulus package this year to lower the
funding burden on local governments.
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44
46
48
50
52
54
56
Index, sa
China: PMI employment indices
2004 2005 2006 2007 2008 2009 2010
PMI - employment
index (Markit)
PMI - employment
index (NBS)
Retail sales value growth (%oya, ytd)
Jun 09 Sep 09 Dec 09 Mar 10
Overall 15.0 15.1 15.5 17.9Food 12.6 12.8 14.0 18.4
Garments/footwear 18.0 16.9 18.8 23.9
Daily-use items 14.0 14.2 15.6 22.4
Furniture 33.3 32.3 35.5 37.6
Construction materials - 21.1 26.6 26.8
utomobiles 18.1 24.5 32.3 39.8
Household electronics 5.1 6.9 12.3 29.6
Cosmetics 17.2 17.6 16.9 15.6
Jewelry 15.4 15.5 15.9 37.3
Consumer staple goods
Consumer durable goods
Luxury consumer goods
5
10
15
20
25
30
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
-4
-2
0
2
4
6
810
CPIM2
(12-month lead)
M2 growth and CPI
%oya, both scales
J.P. Morgan forecast of 2010 CPI
JPMorgan Chase Bank
Qian Wang (852) 2800-7009
[email protected] Ng (852) [email protected]
downturn in exports since 2008 hit the labor market notably,
especially for migrant workers. Earlier in 2009, it was re-
ported that 20 million (15.4% of the 130 million total) migrant
workers in coastal areas had returned home, while remit-
tance of migrant workers salaries usually account for aboutone-third of rural household income. As such, it is encour-
aging to note that temporary labor shortages have emerged
recently in coastal areas and employers have increased sala-
ries as factories are ramping up production to meet foreign
orders. This could attract more workers who had returned
home to rural areas back to the cities. In addition, the em-
ployment component of the manufacturing PMIs has turned
up, reinforcing the outlook for steady improvement in total
employment and hence household income.
On the policy front, the central government has persistently
highlighted domestic demand, especially private consump-
tion, as an important driver of economic growth this year.
Particular focus has been placed on improving the distribu-
tion of national income and enhancing the consumption
capability of lower-income groups. In addition, the authori-
ties have extended into 2010 a series of consumption-related
stimulus measures, including incentives for spending on
autos and home electrical appliances. The authorities also
highlighted the policy target of speeding up the urbaniza-
tion process, with emphasis on encouraging the rural mi-
grant population to settle in urbanized areas, especially in
the medium-sized and smaller cities, which should further
strength the outlook on medium-term consumer demand.
CPI to climb until summer
We expect headline CPI inflation to inch up until summer and
average about 3.2% for 2010, peaking at nearly 4%oya in July/
August. This increase is largely due to a low base, higher food
prices, and continued resource price reform, while core infla-
tion pressure should be well behaved. The super-accommoda-
tive monetary situation last year has triggered market con-
cern that the seeds of inflation have been planted. Some who
worry about inflation argue that M2 growth usually leads CPI
inflation by 12 months. We think this concern may be mis-
placed, as the correlation between M2 growth and consumer
price inflation has significantly weakened in recent years.For example, M2 growth rose 13.5% in October 2004 to
19.1% in May 2006, while nonfood and core CPI stayed
stable, hovering around 1.0% and 0.8%, respectively, during
the period from October 2005 to May 2007. This was prima-
rily due to two factors.
First, excess liquidity in China has largely flowed into asset
markets, resulting in significant asset-price inflation, rather
than real goods/service price inflation. This is because the real
economy has adequate capacity, or even excess capacity, in
many sectors, and many producers lack pricing power. We
believe that last years excess liquidity has largely been ab-
sorbed by the property market and to some extent the com-
modities market. Indeed, along with the 27.6% increase in themoney supply last year, real estate prices jumped 21.1%oya,
the fastest pace since the housing reform in 1999, while the
A-share index surged 79.8%oya.
Second, volatile food pricesparticularly the surge in the price
of pork in 2H07/1H08have dominated the headline inflation
reading in recent years largely due to the shift in the supply
cycle, as opposed to money or demand-pull pressures. How-
ever, the government now has more influence on food prices
through market intervention, and we believe food price infla
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10
40
70
100
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
4
5
6
7
8
9
10
Pork price and hog price/feed cost ratio
%oya
Hog price/feed
cost ratio
Pork price
Live hog/corn price ratio
5.5 = ratio break-even
point for hog -raising
-4
-2
0
2
4
6
8
10
2002 2003 2004 2005 2006 2007 2008 2009 2010
Headline CPI with 2010 forecast and base effect
%oya
Headline CPI
Base effect's contribution
to headline CPI
JPMorgan Chase Bank
Qian Wang (852) 2800-7009
[email protected] Ng (852) [email protected]
tion will also be more moderate than in the last cycle. In January
2009, the government established a pork price stabilization
mechanism based on the hog price/feed cost ratio. In May 2009,
when the ratio temporarily fell below 5, the government started
to increase its inventory, pushing up the price. Thus the ratiostayed comfortably above the breakeven point, ensuring abun-
dant supply this year. According to the stabilization mechanism,
if the ratio nears 9, the government will reduce its inventory to
help immediately cool the price. Meanwhile, the gradual increase
in grain prices last year was driven by higher government pro-
curement prices in a bid to increase farmer income and con-
sumption. The government paused later in the year when farm-
ers began hoarding grain in anticipation of further price in-
creases.
The headline CPI reading fell into the deflationary zone last
year, generating an unfavorable base effect for the headline
figures this year. The base effect will gradually increase until
the summer, contributing to increases in both food and non-
food prices. Starting in late 3Q, the base effect will begin to
moderate, allowing headline inflation to ease. The magnitude
of the base effects contribution to headline CPI is expected to
average about 1.2%-pt in 2010, peaking at 2.1%-pt in July/Au-
gust. This compares to the average contribution of 3.4%-pt in
2008 with a peak of 5.7%-pt in January of that year, when
headline inflation averaged 5.9%. As such, the base effect in
2010 will be unfavorable, but not overly so.
While consumption growth has followed a fairly steady
uptrend, inflation in China is usually more closely associatedwith a surge in FAI growth, which puts upward pressure on in-
put prices that corporates then try to pass on to consumers.
However, for 2010, we expect a notable moderation in FAI
growth, as public spending on infrastructure projects slows and
real estate-related investment moderates from a cooling hous-
ing market. The moderation in demand for investment-related
products could ease some price pressure at both the producer
and consumer levels. While there have been concerns about
rising input costs, partly due to imported inflation, we believe
the most effective way to combat imported inflation is by allow-
ing CNY to appreciate more aggressively. Last but not the
least, we believe the recent wage increases and labor short-
age concerns are driven by both temporary and long-termfactors. Overall, we believe that solid growth in labor produc-
tivity and weak pricing power in the manufacturing sector
will limit the scope of passthrough of any wage increase to
consumer price inflation in the near term.
Macro policy: flexible and targeted
On macro policy outlook, latest policy tone from top
policymakers reiterated the stability and continuity of overall
policies, with supportive fiscal policy and appropriately ac-
commodative monetary policy. However, as top authorities
pledged to strike a balance among maintaining stable and
relatively fast economic growth, pushing for economic re-
structuring, managing inflation expectations, and improving
the quality/efficiency of economic growth, policymakershave emphasized a more flexible and targeted approach
for policy in responding to prevailing macro conditions.
This suggests that policy this year will be data-dependent
and reactive, rather than proactive, and policy-makers will
likely rely more on sector-specific measures. It followed,
then, that the central government, while recognizing that the
economic recovery is now gaining a more solid footing,
stressed a strategy of stabilizing prices by strengthening
price monitoring and penalizing price collusion, and control-
ling housing prices through tighter credit control and tax
policies, while strengthening risk management of local gov-
ernment funding vehicles.
On monetary policy, the central bank will likely continue to
focus on sterilizing excess liquidity through open market
operations and RRR hikes, as well as strengthening credit
control. However, we believe there is still no consensus
among policymakers regarding interest rate hikes. Headline
CPI, in 12-month terms, has been higher than the one-year
deposit rate of 2.25%. This suggests that China already has
had a negative real interest rate for more than three months,
which should temper calls for interest rate hikes to moderate
rising inflation expectations, especially in asset markets.
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6
8
10
12
14
16
18
%
China: reserve requirement ratios for financial institutions
02 04 06 08 10
RRR for large banks
RRR for medium and
small banks
-5
0
5
10
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
0
1
2
3
4
5
China: CPI and one-year real deposit rate, with 2010 forecasts
%oya, %pa
Headline CPI
inflation
Real deposit rate
Nominal 1-year
deposit rate
%pa
90
100
110
120 7
7
8
8
9
Index, 2000=100, + = appreciation
China: CNY REER and CNY/USD spot rate
2005 2006 2007 2008 2009 2010
CNY/USD spot rateReal effective
exchange rate
CNY/USD
spot rate
5
10
15
20
25
30 6.5
7.0
7.5
8.0
8.5
US$ bn, 3mma
China's trade surplus with the US and CNY/USD exchange rate
CNY/USD
03 04 05 06 07 08 09 10
China's trade surplus
with the US
CNY/USD
exchange rate
JPMorgan Chase Bank
Qian Wang (852) 2800-7009
[email protected] Ng (852) [email protected]
However, whether the central bank can win over dovish
voices in the policy debate and hike its benchmark interest
rates soon is a close call.
As we emphasized above, policymakers prefer sector-spe-cific measures to curb asset-price inflation, and the Premier
has continued to highlight uncertainty surrounding the glo-
bal recovery and financial markets. Meanwhile, the latest
data seem to suggest that policy measures implemented
since early this year, including intensified open-market op-
erations, RRR hikes, and credit tightening, have started to
take effect. This could have reduced the urgency for the
central bank to hike interest rates in the near term. Indeed,
some policy-makers believe that China can wait until CPI
inflation reaches 3% to hike interest rates, which is likely to
happen with the CPI report for May (to be released in June).
Overall, we continue to expect three interest rate hikes of
27bp each this year, with the first one in 2Q10. We also ex-
pect two more RRR hikes this year.
Window of opportunity on CNY move
Regarding currency policy, we believe that the delay of the
US Treasury FX report removed one key political risk and
has opened a small window for a CNY move to be imple-
mented before political pressures reintensify ahead of the
US midterm elections. We continue to expect CNY/USD to
resume gradual appreciation in May/June, reaching 6.5 by
the end of 2010, with increasing two-way volatility.
We read the US Treasury Secretary Geithners announce-ment to postpone the semiannual report on international
and exchange rate policies as a friendly gesture from the
Obama administration, a nod acknowledging that external
political pressure is counterproductive in terms of moving
China toward a more flexible exchange rate regime. We also
think that the window for China to resume gradual CNY ap-
preciation this year without the appearance of succumbing
to political pressure is not very wide. The delay of the FX
report could thus temporarily ease the political pressure
fr
