News Room - Business/Economics

Posted on 23 May 2008

Asia's real inflation threat

The seeds of Asia's real inflation threat are growing even as the global slowdown gets underway.

Whether it is sufficient to temporarily take some of the steam out of inflation or not remains an open question. Nonetheless, inflation and measures to contain it will remain Asia's central policy theme for the next couple of years. While Asia is in the process of losing its external driver of growth over the next few quarters, the smooth transition to domestic demand-led growth has been complicated by rapidly rising inflation that will certainly cause further political stress. This is quite disappointing for Asia's pro-growth policy makers who came into 2008 expecting to be able to replace lost foreign demand by propping up local demand via interest rate cuts. Not only can they not cut rates, they may be forced to hike them.

Fight inflation -it is here to stay

Policy makers should be much more worried than we perceive they are about the inflation threat. Yes, we view the current surge in inflation as primarily supply side driven, linked to a spike in commodity prices that will ebb as global growth slows and supply responses kick in. But inflationary expectations are on the rise across the region and labour is clamouring for pay increases. In some cases, like the Philippines, it is populist government administrations that are leading the charge.

To maintain and build their credibility, Asia's monetary policy makers have only one choice. Get inflation under control. Everyone in the region is either an explicit or an implicit inflation targeter, and inflation almost everywhere is above the official target rate. Policy makers must therefore address inflation head on and take the hit to growth. Thus far, we have witnessed a clever mix of fiscal measures to contain inflation, and stimulus coupled with monetary firmness. But this policy tack has a limited life span and addresses only the supply shock. Asia's real monetary policy challenge will mount over the next year.

The real monetary policy challenge builds

The current source of inflationary pressure is not the threat that we have been concerned about. Our concern is linked to the tidal wave of capital that we believe will be coming Asia's way. US-regional interest rate differentials are moving in favour of Asian exchange rates. Sustained capital inflows will be very difficult for Asia to control due to a lack of monetary tools to effectively contain liquidity.

Hiking reserve requirements a la China and India, introducing prudential regulations to prevent asset price inflation (most notably directed toward the real estate sector), sterilisation to absorb liquidity and sovereign wealth funds recycling inflows simply address the symptoms of an undervalued currency region (anchored by the renminbi, much the same as the yen in 1980s). This is clearly reflected in Asia's current account surpluses and sustained rises in foreign exchange reserves through the first quarter of the year.

The dilemma is fairly straightforward. Either the region's currencies led by the renminbi need to appreciate to a much greater extent than we believe policy makers would be comfortable with, or interest rates would have to be allowed to drop below US rates to discourage capital inflows. Stronger exchange rates would result in a boom in fixed asset prices while the lower interest rates would quickly result in economic overheating given how strongly these economies have grown over the past couple of years. As these pressures intensify, the ability of policy makers to control the adjustment process will erode. Something has to give.

In theory the region's monetary authorities ought not to hesitate to raise rates aggressively now to contain inflationary pressures. The current policy settings suggest that inflation will ultimately broaden out a la Vietnam and will likely end in a hard landing. Measures such as the ones mentioned above to slow the process down may buy time but again don't really correct the underlying driver. To be effective Asian economies need to let go of their strict currency controls or the external imbalances won't narrow. This will ultimately result in rapid money supply growth and, subsequently, inflation.

China names the tune

China is still expected to run a current account surplus of more than 7% of its GDP through 2010. To address surging liquidity China will continue to tighten monetary policy. Unfortunately, the US Federal Reserve has been lowering rates while the rest of Asia may be forced to boost rates to combat inflation. This would encourage a further rise in international reserves and the need for further measures to contain money growth which are self defeating.

At the end of the day, the bigger and more serious inflation challenge for Asian policy makers is growing, and its power is much more menacing than the current spike in food and energy prices. Undervalued currencies either appreciate or the economies they support inflate their advantage away. The imbalances have been allowed to become so large the adjustment is likely to be messy. There is no other way out.