ECONOMIC OUTLOOK: HONG KONG

Hong Kong remains one of Asia's best performing economies. Economic growth averaged more than 7% in the past two years, fuelled by rapid export growth and a booming Chinese economy. With the global economy gaining momentum this year and growth in China very strong in the March quarter of 2006, nearterm growth prospects for the territory again look promising.

Indeed, the latest indicators show global economic growth continuing at a remarkably strong pace. Oil prices have more than doubled since late-2003 and much of the latest price jump is unlikely to be unwound soon. Previous oil shocks have been followed by substantial slowing in global economic growth - but that has not occurred this time with growth staying above its 4% long run trend and forecast at 4.5 to 4.75% through 2006 and 2007. NAB has also marked up its growth forecasts for China to 10% in 2006 and 9% in 2007, taking them well above the Chinese government's own projections.

Real GDP Growth (%)	Export Growth (3mma, %yoy)

Exports, which have been the main driver of economic growth in Hong Kong in the past few years, have continued growing strongly as the territory benefits from a surge in external demand for electronics and still-rapid Chinese export growth of 20-30%. Indeed, Hong Kong exports were up more than 12% yearon- year in the March quarter, underpinned by robust trade flows to mainland China - about 80% of Hong Kong's total exports is comprised of re-exports from China.

The monthly data also indicates that domestic demand is supporting the robust growth outlook. Retail sales grew strongly in March. This highlights the ongoing recovery in private consumption, which is holding despite recent increases in interest rates. Retail sales have also been helped by the recent pick up in tourism to Hong Kong (with visitor arrivals up almost 14% year-on-year in the first three months of 2006 to 6.2 million), and the improving employment picture.

Retail Sale & Tourist Arrivals (3mma, %yoy)	Consumer Price Inflation (%yoy)

On balance, NAB expects real GDP growth in Hong Kong to grow by a robust 5.25% in 2006 and 5% in 2007. Some key risks to the growth outlook include high oil prices and the possible spread of bird flu, which could impact negatively on consumption and the tourism sector.

Meanwhile, inflation is still relatively subdued, following successive interest rate increases by the HKMA. However, consumer prices are expected to maintain their steady upward trend, driven by rising housing rents and high oil prices. Overall inflation should, however, remain modest as the labour market continues to undergo structural adjustment and wage gains are contained at modest rates. Consumer price inflation is unlikely to rise above 2.25% in 2006 and 2.25% in 2007.

STRONGER GROWTH PUTTING UPWARD PRESSURE ON INTEREST RATES

The Australian economy has surprised by reaccelerating in the first few months of 2006. Last year domestic demand and confidence had slowed on fears of further rate rises, a weak property market and concerns re oil prices. Evidence of the recent turnaround includes much stronger confidence and conditions in our business surveys (April shows the underlying momentum continuing – see chart below), falling unemployment (5.3% at Dec to 5.1% April) and strong real retail sales (up 1.7% in the Mar quarter). All up domestic demand is now expected to have increased by 5%+ in the year to March 2006.

Growth rates across Australia have, however, been very varied. WA (especially) and QLD have been very strong while NSW (especially) and Vic have been the laggards (eg domestic demand in WA 10% NSW 2%). That reflects industry composition (mining and infrastructure). What is important is that the strengthening in activity in early 2006 appears to be coming from a bottoming out in NSW rather than further strengthening in WA / Qld. In particular it appears that the previously weak cyclical sectors (retail/ wholesale/manufacturing) have been improving – likely to reflect a reacceleration of the wealth effects from stronger equity markets and a bottoming in the property market (especially NSW).

It was in that context that the 2006/07 Budget was delivered. There are two main perspectives on the Budget. At the micro economic level the Budget contains a number of worthwhile longer-run structural reforms. In particular, the scrapping of taxation on superannuation for those aged 60 and above will clearly provide powerful incentive for older Australians to stay in the work force, while some modest attempt has been taken to help alleviate high marginal tax rates at lower income levels (raising thresholds). Lowering the top marginal tax rates and increasing the threshold will be more helpful in encouraging work and saving incentives. Increased funding for infrastructure, both physical (road, rail and water) and human (i.e. health and medical research) should help longer run productivity as will higher depreciation allowances via increased investment.

That said, the stimulus contained in the Budget was also more than we had expected. We had factored in tax cuts of around $8b – whereas the actual cuts plus super benefits were closer to $10b per annum on an ongoing basis. Total additional policy stimulus is around $11b in 2006/07, rising to around $16b per annum in the out years. In a structural sense that is adding 1 to 1.25 percent of GDP to the economy and the structural surplus is now largely eroded (see chart below). Basically the benefits of a stronger economy and high global commodity prices have again been all spent.

To the extent that the Budget adds to growth in an environment of accelerating demand, it clearly adds to the risks of further upward direction in interest rates. Indeed, in our view the Reserve Banks recent 25 point increase in official cash rates very much reflected such concerns. Thus the recent CPI readings for the March quarter pointed to higher oil prices feeding more into core inflation – which has now reached 2.75%. Looking forward we still see core inflation peaking at a touch above the RBA's 3% target. We had previously rated the chance of another rate rise at around 40 percent – the 2006/07 Budget makes further monetary tightening a close call. While we still do not have another rate increase formally built into our forecasts much will depend on the data – any sign of further acceleration of wage price pressures could well see an increase (with the most likely timing in August).

Finally we continue to see GDP growth of around 3.25 % in 2006 rising to around 3.5 % in 2007 (see charts below). This will continue to see the economy operating at high levels of capacity and lower levels of unemployment. Also we remain optimist on global growth (GDP around 3.75 % in 2006 and 3.5% in 2007). That environment remains supportive of commodity prices (i.e. continuing to increase moderately in late 2006 before moving down moderately in 2007). This will also point the AUD staying around 77c till year end then moving down to around .70c through 2007 (in line with commodity forecasts – see charts below).