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Wednesday, July 16, 2008

Asian Growth Engines Face Challenges and Stiff Inflation

By Guneet Singh Sahni

Starting now and on a weekly basis, we will provide you with our expert analysis on the Asian markets and economy. Look for these reports each Sunday or Monday.

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Asian Markets

The past week, ended July 11, saw mixed closings among top Asian indices. Inflation continued to be a major challenge for most of the Asian countries including India, Japan and China.

The world's two fastest growing economies - China and India, the growth engine for the global economy, seem to have hit an impediment in their growth momentum, with both the economies facing tough macro economic challenges. India and China, which were among the world's best performing stock markets throughout 2007, have suddenly become two of the worst performing.

The market now fears of a slowdown for the two. Soaring crude oil and commodity prices, which have more than doubled, continue to put pressure on all major oil consuming economies. Japan's wholesale inflation rate has risen to a 27-year high of 5.6% in June, while India's WPI inflation has touched a 13-year high of 11.89%. The government has been trying to keep a balance between inflation and growth rates. Just the same, the markets will keep a close watch on how central banks for the Asian powerhouses manage the trade-off between rising inflation and slowing growth.

Commenting on the last trading week, Asian markets snapped a four-week loss on the last day. This came on reports that the U.S. government will prevent the collapse of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). China's CSI 300 Index gained 7.7% last week, snapping a seven-week losing streak, while India’s benchmark BSE Sensex closed flat, ending its seventh straight weekly loss.

India Equity Market Briefing

Slow industrial growth and persistent high Inflation make the outlook for the Indian market weak, in my opinion. The Indian market barometer, the BSE Sensex Index, recorded a slight increase of 15 points, or 0.1%, to end at 13,469 for the week ended Friday, July 11, 2008. The last trading day of the week offered a fall of 456 points, or 3.3%, on the back of slowing industrial growth output of 3.8% Y/Y, and against 10.6% growth from a year ago.

The fall was supported by inflation touching a 13-year high of 11.89%, against an expectation of 11.75%. Crude oil has also breached its all-time high of $146 per barrel, which we expect will prove a dampener for the Asian markets. BSE Sensex had earlier in the week made a recovery of 614 points or 4.6%, which was supported by strong global cues. However, it gave away all its gains by the end of the week. With inflation rising, we believe any possibility of the Reserve Bank of India (RBI) softening monetary policy to boost sagging industrial output can be ruled out. The RBI is now facing a policy dilemma, which questions by how much should it worry about the slowdown in industrial growth, and how much the strength of inflation?

Industrial Output Grows Slowest in Six Years

India's industrial output for the month of May slowed down sharply to a rate of 3.8%, as compared to 10.6% a year ago, and against the consensus estimate of 6.7%. This is the slowest pace in more than six years.

Manufacturing output, which accounts for nearly four-fifths of the total weight of the Index of Industrial Production, grew 3.9% in May, as against 6.7% in April and 11.3% a year ago. Within manufacturing, output of capital goods grew 2.5% and consumer durables 4.4%. In May, electricity generation and mining output grew 2.0% and 5.2%, respectively.

India's industrial output during Apr-May, the first two months of the new financial year, grew 5.0% compared with 10.9% in the year ago period. Standard & Poor's said it may cut the nation's credit rating to junk if the economy deteriorates further. The risk of a credit downgrade comes just 18 months after India was lifted to the "investment" category by S&P for the first time since 2002.

Inflation at a 13-year high

We agree with the Reserve Bank of India estimate for WPI (Wholesale Price Index) inflation, which tracks changes in the cost of living on a weekly basis. RBI expects a further increase in WPI to a range of 12-13% in coming weeks, owing to high agricultural commodity prices and recent domestic oil price hike. The weakening rupee is also making imports costlier, another contributing factor to high inflation. With Government's foremost priority to tame inflation growth, the Indian economy is expected to make a relative trade off between inflation and growth. India's central bank, which meets on July 29 to review monetary policy, last month raised its benchmark interest rate twice to a six-year high of 8.5% and lifted its cash reserve ratio to 8.75%. The cash reserve action is meant to prevent money supply in the banking system from stoking inflation.

Growing political difficulty for the UPA Government over India-US nuclear deal

Hot inflation figures have been a major setback for the ruling UPA Government, which faces elections in six states this year and general elections next year. The UPA is already contending with slowing economic growth and waning popularity.

Adding to its woes, the government’s decision to go ahead with the Indo-US nuclear deal has led to a loss of support from Left Part, one of its key allies. Consequently, the government will find difficulty in keeping its majority in the Indian Parliament, and it is expected to face a no confidence motion in the coming week. Higher prices have caused the ruling Congress party to lose elections in nine of eleven state polls since January 2007. The Government has set the fiscal deficit target at 2.5% of GDP. It has also spent $23 billion in Jan-March on food, fertilizer and oil subsidies in order to mitigate the impact of surging global costs of crude oil and other commodities.

The government, in a populist measure, has given a farm loan waiver of $17 billion over the last four months, and plans to raise salaries of 4 million civil servants in the sixth pay commission. These populist measures aimed to gain a foothold for the next election will make it difficult to meet fiscal deficit targets.

Japan equity market briefing

High Oil Prices Hurting Japan’s Economy

The world's second largest economy, which was in a state of deflation for years, is also not isolated from the Asian problem of burgeoning inflation on back of high crude oil and commodity prices. Japan's wholesale inflation rate rose to a 27-year high of 5.6% in June. However, Bank of Japan Governor Masaaki Shirakawa and his six colleagues kept the overnight lending rate at 0.5% this week. Policy makers also reviewed their semi-annual outlook report, first published in April.

Consumer sentiment is at a six-year low, and corporate profits are expected to fall for the first time in seven years. The central bank lowered its assessment of consumer spending in all of Japan's nine regions in its quarterly regional economic report last week. As per the bank's Tankan survey, large cap companies expect profits to decline 7% in fiscal 2008, the first drop since the 2001 recession. A drop in corporate profits, the source for the economy's positive cycle, will definitely discourage companies from making new investment, raising wages or hiring more workers.

Price increases are spreading beyond energy and food to industries such as automakers, which have so far avoided charging more through cost cutting and improving productivity. Hino Motors Ltd. (OTC: HINOY.PK), Japan's largest maker of heavy trucks, and Nissan Diesel Motor Co. (OTC: NSNDF.PK) this month raised prices of vehicles for the first time in almost 17 years to absorb costs.

Japan's current-account surplus narrowed for a third month in May, as oil prices pushed up the import bill. The trade surplus shrank 5.9% to $18.7 billion. A stronger yen is also eroding the value of interest payments that Japanese investors earn abroad. This caused the income surplus to shrink for a second month.

Exports rose 4.2% in May from a year earlier, compared with 4.9% in April. Imports climbed 4%, compared with 13.4% in April. Japan imports virtually all of its oil. Japan's currency has gained about 14% in the past year against the dollar. A stronger local currency cuts the value of exports and interest on securities when repatriated.

China Equity Market Briefing

China's economy has slowed each quarter since expanding 11.9%, the fastest pace in 12 years, between April and June last year. Second-quarter gross domestic product is due to be announced July 17 after a 10.6% expansion in the first three months. Inflation accelerated to 8.1% in the first five months of the year, from 4.8% for all of 2007, posing a threat to economic stability as the nation prepares to host the Olympics next month. The CSI 300 Index, which tracks yuan-denominated A shares listed on China's two exchanges is already down 45% this year, making it one of the world's worst performing markets.

The Central Bank of China has instructed banks to set aside a record amount in reserve after raising interest rates six times last year. The yuan strengthened 0.36% last week to 6.8340 per dollar, as the Government has reaffirmed that the battle against inflation remains its top priority.

The strengthening of the yuan has helped lower import costs as oil prices reached record levels. It has also helped narrow a record trade surplus that has flooded the economy with cash. The June trade surplus narrowed 21% to $21.4 billion from a year earlier. In its efforts to tighten controls on speculative capital, the State Administration of Foreign Exchange said on July 2 that it will require exporters to deposit foreign-currency income, including prepayments, into designated bank accounts from July 14 before the currency regulator confirms authenticity of the revenue and allows it to be converted.

Consequently exporters are hurrying to repatriate earnings from overseas and convert the money to yuan before the start of the new rules. This boosted the demand for the local currency. China's export growth has slowed more than economists estimated in June, putting the government under pressure to cool yuan gains to protect manufacturers.

China's trade surplus narrowed as growth slowed in shipments to the U.S. and the European Union. Imports climbed 31% in June, after a 40% increase in May. The Bank of China said in a report that the yuan's gains will slow in the fourth quarter as policy makers rely more on interest rates and less on currency appreciation to cool prices.

Look for your next Asian market report early next week.

Please see our disclosure at the Wall Street Greek website. Article interests AMEX: DIA, AMEX: SPY, AMEX: DOG, AMEX: SDS, AMEX: QLD, Nasdaq: QQQQ, Nasdaq: ASIA, Nasdaq: PRASX, AMEX: PUA, AMEX: NWD, Nasdaq: MEAFX, Nasdaq: EBASX, Nasdaq: EVASX, Nasdaq: MACSX, Nasdaq: MATFX, AMEX: CZJ.

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