Are Asian Central Banks Still Behind the Inflation Curve?

The spike in food and commodity prices has pushed inflation in Asia to record levels since late 2007. Asian central banks, however, initially abstained from hiking interest rates due to fears of contagion from a U.S. slowdown. Instead, countries like India, Indonesia, Malaysia, Philippines and Vietnam opted to fight food and fuel inflation using non-monetary policy measures like price controls, export restrictions, subsidies and reduction in import tariffs.

Price caps were imposed on commodities like steel, coal and cement; utilities, transport and other public services. Export restrictions or bans were laid on staples like rice, wheat and corn as well as on oil products such as crude, palm and edible oil. In some cases, a minimum export price or export tax was imposed while import duties were also slashed on several food and oil products. Many countries subsidized (and continue to) food, edible oil and fuel, thus veiling the actual inflationary pressure in the economy. India also banned futures trading in food and non-food commodities while Indonesia cracked down on hoarding and smuggling to neighboring Asian countries. Malaysia raised electricity tariffs and provided rebates for the poor while Vietnam cut govt. spending on infrastructure projects. Thailand implemented a $1.3 bn fiscal stimulus package which included tax cuts on gasoline and subsidized utilities and transportation to cushion consumers from inflation.

China and India also used alternative monetary measures such as raising commercial bank reserve requirements. To contain currency depreciation and import inflation, South Korea, Thailand, India and Philippines intervened (and still are) heavily in the FX market. But as the surging subsidy bill threatened to worsen fiscal balances, countries like India, Malaysia and Indonesia rolled back subsidies. However, this further aggravated the price pressures (apart from causing serious political backlash and strikes by workers facing eroding real wages), thus pushing inflation to decade-highs and even to double-digits in Vietnam, India, Philippines, Indonesia (See Figure 1). The un-weighted average Asia (ex-Japan) interest rate stood at 6.69% as of July-end, and inflation at 10.16%, resulting in a negative real interest rate of 3.47%.

As prices continued to accelerate despite aggressive fiscal measures, Asia realized that inflation and negative real interest rates posed a greater threat to their economies than a developed world slowdown. Hence, it was not until May that most central banks began raising interest rates, taking policy rates to all-time high levels (See Figure 2).

While India, Vietnam and Indonesia have pursued aggressive or continued tightening, the Bank of Korea hiked rates only in August to slow the won depreciation and its attendant import inflation. China, which hiked rates in 2007 and subsequently relied on other measures to dampen liquidity and respond to supply shortages, saw inflation fall despite negative real rates. Meanwhile, those most vulnerable to a U.S. slowdown - Malaysia, dollar-pegged Hong Kong and Singapore - have stayed away from tightening to support growth since they believe the oncoming global slowdown will itself help alleviate commodity inflation.

The correction in commodity prices since mid-July might point to a possible peaking of inflation in 2H08 (especially in Malaysia, Singapore, Vietnam). In fact as global crude prices started easing recently, Malaysia and Vietnam reversed some of the past fuel price hike. These trends might tempt Asian central banks to loosen interest rates ahead in order to aid growth as exports are taking a hit from the global slowdown. Such a policy stance might also be called for to alleviate the slowdown consumer spending and investment caused by inflation and recent monetary tightening. Some countries might also be concerned that rising interest rate differential would keep attracting hot , thus exacerbating the domestic liquidity and inflation situation.

However, this should be a temptation best to ignore since second-round price-effects are now emerging via inflation expectations, wage pressures, and high input, transport and production costs, especially in countries like India, Indonesia, Singapore, Vietnam. While commodity prices might ease in the coming months, they will nevertheless remain elevated so that inflation will continue to pose a risk for most countries. Moreover, apart from global factors like food shortages and oil shock, economies like India, Indonesia, Vietnam, Malaysia have faced inflationary pressure owing to strong credit growth, domestic demand and fiscal spending. Ignoring these dangers of price spirals and inflationary expectations could threaten Asia with stagflation that can have detrimental effects on the Asian currency and equity markets.