by NR INDRAN

Asia’s growth has been relatively resilient to US and EU growth downgrades

— We have kept most of our growth forecasts intact. China’s growth has surprised to the upside in 2Q, and while likely to slow in 2H 2011, a hard landing is unlikely in our forecast period.

Asia’s vulnerability to Euro contagion is diminishing — This may be due to improved FX reserve coverage, little/diminishing reliance on wholesale bank funding and low exposure to European banking claims. Inflation concerns have given greater incentive for central banks to keep FX stable even during DXY bounce and Asia benefits from “reverse contagion”/safe haven flows.

We shouldn’t forget inflation — Food deflation/disinflation is over, and commodity-driven inflation risks may be tilted to the upside (e.g. rice) at a time when core inflation remains sticky.

Expect a change in policy mix – less rate hikes, more macroprudential tools

— We think rate hikes are increasingly difficult at this juncture. With still historically low real rates, expect greater usage of reserve requirements as a way to tighten monetary conditions without exacerbating capital inflows. While some FX appreciation will be tolerated, we could eventually see more curbs on ST capital flows if US rates stay low for longer.

Market outlook — We have a more cautious near-term outlook for risk assets but we expect Asia FX to outperform EUR, and like CNY, KRW & IDR; we may see tactical PHP gains if rice-fueled inflation intensifies. Over the medium tem, MYR appears due for a catch up, especially vis-a-vis SGD, whose recent move we wouldn’t chase. After the rates sell-off, we are biased towards steepeners in CH and

KR. We recommend switching out of Vietnam 20s into Sri Lanka 20s.

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