Asia Faces an Inflation Quandary

Although inflation’s grip is rising on most of Asia, policymakers are stymied about what to do. Almost any course appears set to more harm than good. Whatever the policy followed, the end result is going to be that Asian developing countries’ export competitiveness will suffer because commodity-driven inflation, and particularly food inflation, has a bigger impact on them than on developed economies.

With the cyclone disaster in Burma having wiped out that country’s ability to export rice to either Bangladesh or Sri Lanka, and indeed probably making it necessary for imports to Burma, rice prices, already high, can be expected to explode, adding to the problem.

Possible responses to inflation include tighter monetary policy and higher interest rates, stronger currencies to limit imported inflation, consumer subsidies, export controls – or doing nothing. In the event, all have been tried, in whole or part, as Asian governments come under increased pressure to do more, even if only for show.

Nowhere is the dilemma more acute than in Vietnam, which currently tops the consumer inflation league table at around 20 percent annually. In a seemingly belated response, the government dramatically tightened money supply growth, driving up interest rates and causing the country’s stock and real estate prices to crash. But the connection between consumer prices and money supply was tenuous. For sure, money had been far too loose for too long as Vietnam basked in international esteem and capital inflows. But the main inflation culprit was food, with prices up 35 percent thanks in large part to Vietnam’s open economy and role as a major food exporter – particularly of rice and fish.

Belated efforts to dampen domestic prices by limiting exports merely served to add to panic in importing countries like the Philippines which had failed to keep adequate stocks.

Now the pressure is on Vietnam to try another tack in its inflation fight – allow the dong, which has fallen against almost every currency except the US dollar, to appreciate significantly as it likely would given continued capital flows and strong commodity exports. But it isn’t that simple. The government and private sectors alike recognize that workers must be compensated for rising prices, so double-digit wage rises are in prospect. Combined with dong appreciation, that could undercut competitiveness just at the time when markets in the west are already weak and those in Asia are going off the boil.

China is already feeling some of that pressure. Food inflation is lower than in Vietnam but at 21 percent it has been driving the 8 percent CPI rate. Currency appreciation is beginning to bite some low end manufacturing and that looks likely to get worse. Export prices have been rising more slowly than other prices, suggesting that exporters’ profits are being severely squeezed and will also have to be raised to take account of rising prices for items such as iron ore and coal, which have yet to make their way through the price chain.

Indonesia is the latest economy to struggle with a rising CPI, with inflation spiking up to 9 percent in April and with additional fuel price hikes expected in June. At the other end of the inflation league table is Malaysia, where consumer prices are up only 2.8 percent although perceptions of rising prices played a role in the recent national election that cost the ruling national coalition its historic two-thirds majority in parliament. Continued gradual appreciation of the ringgit looks set to continue at least while commodity prices are strong and the current account surplus remains massive – now at 16 percent of GDP.

But appreciation is a secondary factor in the low inflation. Money growth has remained strong, suggesting that an interest rate increase may be justified. The healthy look of Malaysia’s CPI is largely a result of subsidies and price controls on fuel and basic foodstuffs. This looks good in the short term but is absorbing one third of government spending. It is poor use of available resources and is adding to public debt at a time when the economy remains buoyant thanks to unusually favorable terms of trade. It will have to be unwound at some point – unless commodity prices collapse, dealing a different and more severe blow to the economy.

Elsewhere, in India, Indonesia and now the Philippines, subsidies, at least for the poorest, are a partial answer to the food price problem. But in India and the Philippines in particular they add to existing serious budget problems. India however does have a strong case for tighter monetary policy after a period of being carried away by India-rising euphoria and the impact of massive inflows of (mostly short term) capital which could yet cause balance-of-payments angst again.

China is rather similar – though its trade account is much healthier. It still needs to tighten its monetary policy but has shied away from either sharp increases in interest rates or a one-off big revaluation of the yuan rather than the current creeping appreciation which merely encourages speculative inflow and makes it doubly difficult to rein in credit growth.

The two countries in the region which have welcomed and indeed encouraged significant currency appreciation as an antidote to inflation are both developed economies – Singapore and Taiwan.

As for doing nothing, the nearest case is Thailand , which has imposed no export controls and tolerated further baht appreciation. Given the importance of food exports and the rural vote base of the Samak government, that is not surprising – though it is in keeping with the Bank of Thailand’s philosophy.

Most governments accept that sustained inflation, continuing even once food and energy stabilize, will ultimately undermine export competitiveness. But most believe this is preferable to sharp currency appreciation, which anyway may have only limited impact on inflation.

The bottom line may be that it is the US which has set the tone, making cheap money and negative interest rates its answer both to the problems of the credit markets and the squeeze on consumer spending flowing from energy prices. Others have followed suit to a greater (China) or lesser (EU) extent.

This is much the same situation as prevailed after the early 1970s oil price shock, when crude prices rose more dramatically than now, but other commodities less so. But the combination of cheap money and expensive commodities produced the era of stagflation – lots of inflation and economic stagnation. That sounds bad but the alternative might have been worse – lower inflation but a demand collapse reminiscent of the Asian crisis of 1997-1998.