Asia’s Inflation Dilemma

Is last week’s surprise hike to 9 percent in the Reserve Bank of India’s interest rate the harbinger of interest rate increases across Asia? Or is India an exceptional case, both in terms of its macroeconomic situation and the timing of its rise?

Central banks and governments everywhere are faced with the dilemma: For sure, inflation is high and interest rates in real terms mostly at or near negative throughout the region. But many argue that with oil and food prices both off their peaks, the worst has passed. Thus interest rate rises would merely compound the problems of slowing global growth as US demand stagnates and even China’s expansion might suddenly shrivel. In which case rate hikes would be worse than too late.

Asian Development Bank of chief economist Ifsal Ali has been his usual (but rare for the ADB) outspoken self by saying that higher rates are needed in most countries. But governments, which mostly have a deciding influence over central banks, prefer to believe that inflation is a passing phenomenon driven by global factors beyond their control – oil and food. Even those who believe that rate rises are justified in theory because of high rates of preceding money supply and asset price growth will resist them while the US, China and Japan continue to keep them very low.

India’s situation is different for two main reasons, but it still has lessons for the others. India’s headline inflation rate is now around 12 percent but the moving average is more like 7-8 percent so a 9 percent Reserve Bank of India rate, which translates into 12 percent or more rates for corporate borrowers, is quite steep and unlikely to go higher. But India has two problems not faced elsewhere in Asia – a public sector deficit boosted by subsidies which has ballooned to 8-9 percent of GDP, and a sharply rising current account deficit as well as excessive reliance on debt and equity capital inflows compared with foreign direct investment.

Though reserves are now very big, capital outflow could well bring the rupee down another 10 percent against the dollar and add to inflationary momentum. A sharp decline in Indian growth is on the cards anyway and a bad monsoon could create major disappointments.

But the fact that other countries mostly have lower inflation, current accounts in surplus or close to balance and public sector deficits at manageable levels does not mean that higher rates are not justified.

Take Malaysia. With a current account surplus of around 15 percent of GDP, Bank Negara Malaysia’s rates have been held steady at 3.5 percent throughout the economic cycle. Inflation has been temporarily boosted by oil price rises and the reduction in subsidies but the full year rise is likely to be over 5 percent and looks unlikely to fall below 3 percent in 2009. It seems unlikely that low rates are doing much to spur investment, at least judging by the massive capital outflow.

Rate rises would hurt overextended car buyers in particular, but low rates also are impeding a further – and justified – ringgit strengthening. A stronger currency would help dampen consumer prices while transferring some of Malaysia’s huge terms-of-trade gains from the corporate sector (notably Petronas and the plantation companies) to consumers.

An unpopular government is reluctant to raise rates so soon after the petrol price rise. But pressure for wage rises will not abate and whatever happens in the short term to oil and food, there are many end-product price rises in the pipeline as past rises in raw materials from iron and copper to cement and plastics flow through to the consumer price index. Finally too the fixation with competitiveness and export-led growth continues to deter interest rate and currency increases particularly while the US, China and even Japan put other interests – Wall Street bailout for the US, growth at any cost for China, policy deadlock in Japan - before inflation.

A weak currency can be more damaging than a strong one. The Thai baht appreciated even during the period of political uncertainty following the 2006 coup as the Bank of Thailand appeared ahead of the curve with its inflation-targeting policy. But unwillingness to raise rates in the face of global price rises has since seen a baht decline even against a shaky dollar. Politics is only one reason. Thailand is probably a small net beneficiary of commodity prices, with agricultural exports offsetting fuel imports. The current account has remained roughly in balance and economic growth at a respectable if unremarkable 5 percent.

The Bank of Thailand is now under criticism from the government, which blames it for the weakening baht while at the same time criticizing its recent 25 basis point rise to 3.5 percent, the first in two years. Meanwhile the government is trying to stimulate an economy in which inflation remains a bigger problem than growth and whose exports are less dependent on the US than any economy in Asia.

Korea is another country where political pressures from an unpopular government have held back rate rises. Korea and Taiwan are in fact the only economies in the region to have positive – if only just rates. Korea’s strong trade position has confounded skeptics who believed that it would be hard hit by energy prices and a slowing US. These concerns had helped drive the once-strong won down by 10 percent against the dollar and even more against the yen and yuan.

With inflation now 5 percent and unlikely to fall fast, there is s strong case to raise rates and see the won back at the 900-950 level to the dollar where it was in early 2007. But the government prefers other measures to try to massage the inflation numbers and any weakening of oil prices becomes an excuse for denying the existence of deeper-rooted inflation. Taiwan’s inflation rate remains lowest of all but interest rates have not kept pace with its increase. Low rates have seen the currency rise only marginally against the dollar and fall against the Chinese Yuan despite a continued large current account surplus.

Quite how deeply rooted inflation has become is perhaps best seen by looking at two small but exposed economies in which neither food nor energy play a critical role in consumer prices. One is normally ultra-stable Singapore, whose headline inflation hit 7 percent. Hong Kong would have seen the same but for government subsidies – in this case a temporary moratorium on property taxes – which cut the headline rate by at least one percentage point to 6 percent. Hong Kong’s case can be partly blamed on a weak dollar-linked currency and its dependence on China for many consumer goods. But Singapore’s currency has appreciated significantly.

Both in Hong Kong and Singapore the rise in prices seems to reflect, albeit belatedly, several years of rapid money growth combined with low interest rates, which for long spawned asset price booms. The global money excesses shifted first into commodities and have since spread wider, igniting pressure for compensatory wage increases. Although most countries have surplus labor and many keep a tight grip on unionism and collective bargaining, wage rises may be delayed but cannot be resisted.

Hong Kong has had a rash of strikes forcing 6 percent or so wage hikes and in China a combination of labor shortages in some areas plus the introduction of new labor laws have added to wage costs. In countries ranging from the US to China, Malaysia to Japan the previous few years had seen sharp rises in profits relative to wages. That may now be going into reverse and a struggle for income shares help sustain inflationary pressures. Higher interest rates would have a mixed impact on this equation but if inflation is ultimately about the supply of money relative to goods, a sustained period of lower money growth looks inevitable if inflation at 3 percent plus is not to become entrenched.

Asia in particular does not need the kind of liquidity creation and public deficits being doled out by a US Treasury Secretary who, as boss of Goldman Sachs, helped create the Wall Street bubble. There are no banking crises and only isolated real estate bubbles. Asia does not need to wait for a US move before tightening. Has India produced a surprise that others can follow? Or will they assume that India is an exceptional case and carry on with the illusion that inflation is caused by someone else?