Wednesday, 3 February 2010

Asia fiddles as inflation fears resurface

2 Feb 10 07:51:58, Alan Wheatley, China Economics Editor BEIJING (Reuters)

Last year was tough for Asia's economy but easy for its central bankers. All they had to do was flood their banking systems with lots of cheap cash and sit tight. But in 2010 they are going to have to earn their money.Worries about growth have quickly given way to concerns about inflation, and investors seem split down the middle about the capacity of central banks to rise to the challenge.

As global jitters over China's initial tightening of monetary policy demonstrate, some fear the response will be too harsh. Others, though, fret that some central banks, for instance in India and South Korea, are already falling behind the policy curve and will upset financial markets when they are finally forced to squeeze inflation out of the system.

For when it comes to monetary policy, a stitch in time often really does save nine. Rob Subbaraman, chief Asia economist at Nomura in Hong Kong, said the biggest risk facing Asia was that of an unexpected surge in commodity prices driving up inflation. Part of the problem is that policymakers, still fearful of an economic double-dip in the West, are wary of withdrawing fiscal stimulus and do not want their currencies to rise too fast.

And because the Federal Reserve is unlikely to raise U.S. interest rates until the second half of this year, Asian central banks will probably keep their own rates too low for too long for fear of attracting speculative money. As a result, Nomura expects inflation-adjusted borrowing costs in eight of the 12 countries it tracks to be negative by June -- a recipe for bubbly domestic demand and asset prices."When we look at the region now collectively, monetary and fiscal policies have never been so loose," Subbaraman said.

J.P. Morgan expects interest rates to be rising in some countries by early spring, but at a tepid pace relative to Asia's economic backdrop. The bank's economists reckon the average interest rate in emerging Asia will remain three percentage points below the level implied by a widely followed rule of thumb devised by the U.S. economist, John Taylor.

Central banks, a number of them under political pressure to keep borrowing costs low, instead have contented themselves so far with measures to mop up some of the surplus cash they injected into their economies. "Normalisation" of super-loose policy, not tightening, is the ugly buzzword. For instance, India and China last month increased the proportion of deposits that banks must keep with the central bank, instead of lending them out, while the Philippines raised a rate on a short-term lending facility. None of them increased their benchmark interest rates.

Given that the Reserve Bank of India on Friday issued a sharp warning over inflation at the same time as it tightened required reserves, a half point increase in interest rates is likely to follow next month, Prakriti Sofat and Rahul Bajoria of Barclays Capital said."However, based on our meetings with a number of Asian central banks, the clear theme is that policymakers remain cautious, and the risks are that rate hikes may be delayed," they wrote in a report.

The case for pre-emptive action is based not only on Asia's rapid economic recovery, which is absorbing the spare capacity and excess labour needed to keep a lid on prices. It is also justified, some economists believe, because a repeat of the 2007/2008 spike in global food prices is taking shape.

Western central banks play down passing increases in the cost of food because it typically accounts for just 10-15 percent of the consumer price index. In Asia ex-Japan, though, food makes up 30-35 percent of the CPI, so a jump can quickly boost overall inflation and harden expectations of a price spiral.

Glenn Maguire, chief Asia economist at Societe Generale in Hong Kong, is among the worriers. He says the upswing in food commodity prices since 2004 has been rivalled only twice in the last century -- in the 1930s during the recovery from the Great Depression and during the commodity boom of the 1970s.

He postulates that China could be having a profound impact on food inflation as strong income growth, rapid urbanisation and westernisation of the local diet boost demand."The speed at which inflation is turning in Asia argues for a much more prudent stance on policy, and there are few Asian economies that should be exempt from tightening over the course of 2010," Maguire said.

A more optimistic view comes from economists Silvia Liu and T.J. Bond at Bank of America Merrill Lynch in Hong Kong. Leaving aside China and India, the only two countries with billion-plus populations, the economists said year-on-year food inflation had moderated in Asia to 1.3 percent in the fourth quarter of 2009 from 4.8 percent in the second quarter. The memory of 2008, when inflation peaked in mid-year at 8.5 percent, up 5.6 percentage points from the year before, remains vivid, Liu and Bond wrote in a weekly report.

But they think a better comparison is with 2004, when inflation crested at 4.2 percent, up 2.6 points from the year before.They expect Asian inflation to accelerate to 3.5 percent in 2010 from 0.7 percent in 2009.But they acknowledged that conditions could change. "In particular, if China maintains a rigid FX regime, the entire region may find it difficult to tighten monetary policy, given the low levels of U.S. rates. As a result, asset prices, money, and credit growth could all rise, raising inflation risks in 2011. This is the key risk we will monitor over the course of the year," they wrote.

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