The challenge of two inflations

• We stick with our view about a US recession and a China slowdown this year
• Asset prices are falling. We believe commodity prices will soften, but food prices will remain high.
• These will present significant risks to the global economy, requiring calculated but different policy responses for different economies
• Meanwhile, there has been significant development in northeast Asia, especially across the Taiwan Straits, which could, in the long run, contribute positively to regional growth and economic integration
• Analysis inside on Australia, China, Singapore, Thailand, UAE and the US
• Plus focuses on Asia, Africa, FX and Commodities

Synopsis
Monthly Analysis of Asian, African, Middle Eastern Economies - 17 April 2008

CPI should mean China Price Index

Overview: Overview: Assessing the inflation risk
Is inflation a problem? In rcent years the world economy has boomed, but that boom did not trigger the type of inflation that one might normally have expected. Now, in most countries, headline inflation rates are rising despite intense global competition, as food and energy prices rise. Here, China has played an interesting role.

Asia: Cross beyond straits
Progress in relations between the two sides of the Taiwan Straits is significant, though incremental. It underlines strong public demand, not just individual wisdom. In the long run, economic interdependency is the best tool to secure economic security and prosperity, especially for Taiwan.

Africa: Economies in transition: the case of South Africa
While the end of apartheid in April 1994 was a defining moment in South Africa's political transition to a free, inclusive democracy, the economic transition had really only just started. Labour market data provides just one of the information sets scrutinised for greater insight into this transition and the bigger questions that emerge.

FX: From inflation to growth
The US financial crisis remains the dominant theme in the FX market. We expect the USD to fall further against those currencies supported by strong fundamentals. In EM, our focus remains on long C/A surplus, short C/A deficit currencies.

Commodities: The consequences of high grain prices for Africa
Food price inflation is back with a vengeance. And the security implications have been highlighted by food riots in various countries. There is no single causal factor, but contributing elements include supply shocks for specific products, persistent demand growth, changing tastes driven by rising incomes, high energy and fertilizer costs, and growing bio-fuel demand.

Australia: A tough balancing act

China: The great slowdown

Singapore: Getting tough

Thailand: Time to rebalance

UAE: Sailing in a rough sea

US: How bad a recession?

Forecasts and Sovereign risk tables

OVERVIEW

Gerard Lyons
Chief Economist and Group Head of Global Research, +44 20 7280 6988,
Gerard.Lyons@standardchartered.com

• Emerging economies face the same challenge as food and energy prices rise
• There is still intense competition for traded goods
• Asset price inflation a risk in economies linked to the dollar

Assessing the inflation risk

Is inflation a problem? This is one of the key global issues at the moment. In recent years the world economy has boomed, but that boom did not trigger the type of inflation that one might normally have expected with rapid economic growth. Instead, most headline rates of inflation around the world have stayed relatively low in recent years. Now, in most countries, headline rates of inflation are rising, despite intense global competition, as food and energy prices rise.

Low headline inflation

The International Monetary Fund's (IMF) measure of global inflation provides a good insight into the recent favourable inflation environment. According to the IMF, consumer price inflation in the emerging and developing countries averaged 51.4% during the 1990s, but in recent years has been only 6.6% (in 2003), 5.9% (2004), 5.7% (2005), 5.4% (2006), rising to 6.4% in 2007. Thus current inflation worries need to be put in the context of what went before. Even allowing for this, there is no room for complacency. The IMF expects 7.4% consumer price inflation this year, decelerating to 5.7% in 2009 and 4.5% in 2010. This is low. Many regions have seen dramatic improvements over recent decades, such as Africa and Eastern Europe.

Developing Asia, meanwhile, saw relatively low inflation through the 1990s of 8.6%, decelerating in the early part of this decade before picking up in recent years from 3.8% in 2005 to 4.1% in 2006 and 5.3% in 2007, and is expected by the IMF to reach 5.9% this year. The IMF includes Hong Kong, Singapore, Korea and Taiwan in advanced economies, whilst China and other Asian economies are included in developing Asia – this definition breakdown does not alter the overall picture.

For the advanced economies, consumer price inflation averaged 3.0% during the 1990s, and the highest it has reached on an annual basis this decade was 2.4% in 2006; but this year the IMF is expecting 2.6%, led by the US. The GDP deflator, a broader measure of inflation, shows a similar trend for the industrialised economies, albeit at slightly lower rates.

Many factors

Many factors accounted for this period of relatively low inflation in recent years. Some key ones were:

• The world boom occurred after a period of relatively moderate growth, and thus there was ample spare capacity in the world economy. That is, there was plenty of scope for growth to accelerate before any bottlenecks were hit.
• The emergence of China. The shift of global manufacturing from the West to the East has been an ongoing feature of recent decades which have seen Asia move from producing cheap, low quality goods to producing cheap, but much higher quality goods. China has resulted in a flood of cheap goods and has ensured the scale and pace of change is far more dramatic. And despite the appreciation of the CNY, these goods are still much cheaper than the places in the West in which they might previously have been produced. The share of world GDP that is moving to the developing world is rising. Indeed, I have often said that CPI figures (consumer price indices) should have been renamed China Price Indices, such was the impact of China!
• China's increased production of cheap goods has had a profound impact on global competition too, forcing firms around the world to squeeze further savings out of their supply chain. This is still an on-going development.
• A vital factor contributing to low global inflation has been the credible macro-economic policy environment. Take Africa for example, where a decade ago high inflation, depreciating currencies and high interest rates were typical of most countries. Now currencies are more stable, rates lower. But, more generally, in many countries around the world, political parties on the Left and the Right have often adopted similar, anti-inflationary monetary policies.

Asset price inflation

Yet, the picture was not that clear cut. There has been much debate about whether inflation has been measured properly, particularly in the US. I am not convinced by the criticism of the data, but one has to be sure about what the inflation measure is actually measuring! As we have said many times, even though headline inflation as measured by consumer price figures have been low in recent years, there has been inflation but in other areas.

In particular, whilst headline inflation has been low, in recent years we have seen rapid asset price inflation in many countries, with rising prices of real estate and equities. In many instances this has not been captured in the headline inflation measures.

Meanwhile, there is still intense global competition in internationally traded goods. The appreciation of the CNY is adding to concern that China's deflationary impact is disappearing.

Now asset prices are falling in many places. But instead we are seeing a rise in the relative prices of some food and energy. These are captured in the main inflation measures. Indeed, sometimes they are a large component. For instance, in China, food makes up about a third of the basket. This is leading to a focus again on so-called cost-push inflation, and whether rising costs of key factors can lead to overall inflation. The last time there was a global focus on cost-push inflation was in the 1970s, when oil prices rose. How this feeds through in inflation depends, crucially, on two factors – the reaction of central banks and whether they accommodate this pick-up in prices or not – and whether the rise in costs feeds through into higher wages and into higher inflation expectations. On that the jury is still out. In many poor countries, riots in reaction to higher food prices are often not a sign of rising inflation but more a reaction to an increase in prices that is not feeding through into higher wages, and is both reducing the amount of food that people can buy and also squeezing the amount that they can spend on other items. This deflationary impact of rising food prices is often overlooked. This explains the present challenge.

Over the last one hundred and fifty years, in real terms, after allowing for inflation, commodity prices tend to fall. But the question is whether China and India are fundamentally changing this? The sheer scale of the demand for commodities as both countries open up will exert tremendous upward pressure on prices. What remains to be seen is whether supply can respond. In terms of food prices, there is no shortage of land or labour, often the problem is low farm productivity and the absence of investment. That is, there needs to be a supply side response, but that will take some time to be seen and, even then, it is not clear how effective it will be. All in all, it adds to the perception that whilst commodity prices may ease during the coming cyclical slowdown, they will establish new, higher equilibrium levels, which whilst good for commodity exporters, will not be good for importers.

A snapshot of some countries highlights the challenging environment. All figures are year-on-year rises:

• Singapore: Inflation 6.6% (Feb) and rising. Monetary growth eased from a peak of 23.6% last summer. The Monetary Authority of Singapore had a one-off tightening in its April monetary policy statement.
• Malaysia: Its low headline print of 2.7% (Feb) does not tell the full story as subsidies on fuel help explain this. Money supply growth reaches 11%, off its peak of 14% in early 2007. Steady monetary policy.
• Vietnam: 19.4% inflation in March, and rising, and the country's large trade deficit means that dong appreciation to cap import prices is not possible. Money supply and loan data are not released regularly but authorities hope to cap loan growth at 30% this year.
• Indonesia: Food and energy pushed inflation to 8.2% in April, the highest since October 2006, and this has forced Bank Indonesia to shift policy, with rates now likely to rise. Monetary growth just above last year's average of 16%.
• Thailand: 5.3% inflation in March, but the core rate is less than 2% and well within the 0-3% target. Monetary growth slowed to 1.9% in February, averaging 3.8% last year.
• Hong Kong: Headline inflation of 6.3% in February, the highest since August 1997, with food up 10.8%. Rapid credit growth. New mortgage loans rose 134.6% in February, the highest since March 2004; overall mortgage loans up 7.6%. HKMA said a 10% dollar depreciation adds 0.82% to prices in the short run and 1.61% in the medium term.
• India: Inflation reached 7.41% at the end of March, adding to political concerns, and set to rise further as commodity prices rise, and to stay above the Reserve Bank of India's 5% tolerance level. Credit growth of 21.6% in March, compares with 28.1% last year.
• Korea: March CPI of 3.9% up from 3.6% in February. Money supply M2 growth was 13% in March. The Monetary Policy Committee kept official rates at 5% in April, given high inflation and liquidity growth, but rates likely to fall, given worries about slowing economic growth.
• Taiwan: Inflation has started to rise since the second half of last year, but annual growth rates in monetary aggregates and deposits have been on a declining trend since 2004.
• Philippines: Inflation rose to a 21 month high of 6.4% in March, as rice prices rose. Monetary growth has slowed from 2007's high of 26.3% to 6.6% in March.
• China: The authorities' 4.8% inflation target for this year looks optimistic, even though inflation eased in March, to 8.3% from 8.7% in February. The central bank governor still sounds very hawkish, despite the fact that the loan quota appears to be biting in terms of curbing loan growth.
• South Africa: 9.4% inflation in February and we expect it to stay above 8% all year, with a return to the 3%-6% target range unlikely until H2 of next year. Monetary growth, whilst high around 20%, is well off the 30% peak of this cycle.

Whom to be blamed?

Former Fed Chairman Alan Greenspan has come under severe criticism for not tightening monetary policy to curb asset price inflation earlier, but his response is understandable, he and the Fed can't be blamed for the behaviour of private individuals, and for the fact that the asset price inflation seen in the US was repeated in, as he said, about twenty other countries. It has to be said that at the time there were many suggestions that the rapid pace of credit and lending growth and the rise in asset prices meant that monetary policy was too lax. Although Europe, it was said, opted for stability at the expense of growth, whilst the US favoured growth at the expense of stability, even within Europe there have been problems, with asset price inflation evident in a number of countries, such as Spain or Ireland.

In the late 80s a similar debate took place in Japan at a time when its economy was bubbling. Headline inflation was low, but asset prices were soaring. The then BOJ Governor Mieno decided to tighten monetary policy, raising rates from 2% to 6%. The economy slumped! And the BOJ was partly blamed. Let me quote from a speech by the BOJ Governor in 2000 reflecting on that late 80s period.... “One prominent feature which characterized the bubble period in Japan was the euphoric sentiment which prevailed in every segment of society, and which led to extremely bullish expectations. In this regard, we think it is not sufficient to understand the bubble solely in terms of the rise in asset prices such as property and equity prices... the bubble economy is defined as a combination of the rapid increase in asset prices, the expansion of monetary aggregates, and the overheating of economic activity.... a number of factors were intertwined in the background of such euphoria, and monetary easing was certainly one of them. Monetary easing was a necessary condition for the emergence of the bubble, and to that extent should be held responsible. But, in our defense, I have to say that if we had tried to prevent the emergence and expansion of a bubble by monetary policy alone, we would have had to raise interest rates to levels which could not be justified because of the relatively stable prices at the time.”

Thus it is vital to look at monetary growth and wider credit and liquidity. Measuring liquidity is hard; sometimes economists look at measures such as Marshallian k that look at monetary base in relation to an economy's nominal GDP. Others prefer to look at overall monetary and credit growth. But, also, as has been seen in recent years, an increasing number of central banks have adopted inflation targets, although these may not give the full story.

What to do?

What then should policymakers do? It is important that they identify where the real problem lies. In the US, as we have said before, inflation is not the problem, a deep, long recession is. Firms will have to absorb higher costs in their margins, as weakening consumption means firms will not be able to pass on higher prices. In this environment the Fed will, rightly, ease, and as corporate profits are squeezed, bond yields will respond by heading lower.

In contrast, a number of countries that are tied to the dollar may see inflation problems escalate. Here, in particular, I am thinking of Hong Kong and the Gulf countries. Being tied to the dollar means lower interest rates, at a time when their buoyant domestic economies really need monetary tightening. The result will be rising inflation, particularly asset prices, but also as wages have risen sharply across the Gulf, broader inflation measures may continue to rise.

Of course, economies like China and India, where there has been strong domestic demand, have been tightening for some time with higher rates, rising reserve ratios and, in the case of China, loan quotas. China's current account surplus gives it more room for policy manoeuver. In the early 1990s China suffered both an inflation and a balance of payments problem. Now, its external position is sound, and policymakers are more focused on inflation and trying to achieve a more sustainable pace of growth. In contrast, India's deficit leaves its currency more vulnerable to near-term shifts in risk sentiment despite its many long-term positive factors.

As for Asian countries, policymakers may opt for a combination of domestic monetary tightening or currency appreciation. For now, it seems many central banks are taking a proactive approach, with the attraction of currency appreciation to reduce imported costs potentially gathering ground.

Overall, there is still intense global competition. Furthermore the scope for large numbers of workers to join the global labour force, with low wages and potentially rising productivity, adds to the prospect of further competition for some time. However, there is a need to look at each country's situation on its own merits, taking into account credit and monetary growth, wage and inflation expectations, the amount of spare capacity and above all, the likely response of policy makers. Inflation may be a problem but the reality is far more complex and as Japan showed, an inflation fear, if badly handled, can soon turn into a deflationary reality.

Asia

Nicholas Kwan
Regional Head of Research, Asia, +852 2821 1013,
Nicholas.Kwan@standardchartered.com

• Progress in cross-straits relations is significant, though incremental
• It underlines strong public demand, not just individual wisdom
• Economic interdependency is the best tool to security and prosperity

Cross beyond straits

Small steps, big changes

Among the various new developments in Asia, one widely publicised but not very well appreciated event is the warming of relations across the Taiwan Straits. So much attention has been placed on the short-term political mileage to be gained by both sides of the Straits that the longer-term economic implications have been overlooked. We do not believe there will be rapid political reconciliation between Beijing and Taipei. Any near-term progress will be in small steps. But we also believe that the long-term economic impact of the rapprochement will go well beyond the Straits.

Move driven by public demand, not individual wisdom

The current rapprochement between Beijing and Taipei did not come out of nowhere. It is the result of a long process of political awakening, as both sides have become more pragmatic. We see this same trend throughout the region, as we elaborated in the March issue of this monthly (Standard Chartered Global Focus 20 March 2008 issue, 'Asia: The rise of pragmatism'). On the surface, what we are seeing is a new diplomatic initiative by leaders in Beijing and Taipei. In reality, it is a development driven largely by public demand on both sides of the Straits. Yes, it is not the first time that both governments have agreed to talk, and it may not be the last time they (probably) will end up agreeing to disagree. But even so, it will not be a simple circular movement. Over the years, despite the on-and-off nature of cross-straits political contacts, progress in economic exchange has kept going. Economic trends have gradually demystified many of the political taboos, driving policymakers to adopt more pragmatic policies.

The best defence is co-prosperity

Among the core obstacles to better cross-straits relations is the rivalry of the two governments, who are technically still at war. Security is therefore a high priority, especially for Taiwan, which easily sees itself as in an inferior position given its size. This naturally leads to policies that limit the island's dependency on the Mainland by restraining its linkages across the Straits. Yet, reality has proven that this strategy is hard to implement. Despite all the restrictions, the Mainland has emerged as the single largest export market and offshore investment destination for Taiwan companies, and is also the most favourable destination for Taiwan tourists and travellers, as shown in charts 1 and 2.

However, the restrictions on cross-straits travel, trade and investment are much more effective in limiting the flows from the Mainland to the island. Taiwan's imports from the Mainland amounted to USD 28bn in 2007, hardly half of its exports to the Mainland. Only a quarter of a million Mainland visitors managed to visit Taiwan in 2007, and Mainland Chinese investment in Taiwan remains basically non-existent. While some may cheer these asymmetric flows as a successful result of the no-contact and non-dependency policy, ironically, the actual effect is the reverse. With so many Taiwan-based companies now investing and operating in the Mainland, but only a few in the other way round, Taiwan would suffer more than the Mainland if the trade and investment ties were disrupted.

True that stern cross-straits restrictions have forced many Taiwan investors in the Mainland to maintain minimal contact or to cut their linkages with their Taiwan home-bases, reducing the negative impact on their Mainland and Taiwan operations at times of tension, thus reducing inter-dependency. However, it is also true that such restrictions have imposed unnecessary costs on Taiwanese investors and restricted their competitiveness and growth potential. More damaging, in the long run, the lack of backward linkages has limited the filtering through of benefits from these investments, either in terms of income remittances or rationalisation of organisation and operations. This is also a unique feature of Taiwanese investment in the Mainland when compared with that of South Korea, Hong Kong and others. Usually, strong vertical or horizontal linkages are built between the home-base and the host facilities in the Mainland to enable investors to optimise their operations across borders, allowing the home-base to move up the value-chain. For example, many Hong Kong investors moved their manufacturing operations, especially those labour and land intensive ones, to the Mainland and kept their design, merchandising, marketing and other higher value-added functions in the city.

Even in terms of dependency, the restricted-contact policy does not work. In today's economy, dependency is not determined by the intensity and frequency of contacts and linkages, but by the nature of the linkages themselves. A factory owner may be dependent on his workers to produce and profit, but his workers are also and even more dependent on the owner to make a living, especially when capital is in short supply and labour is not. In the case of cross-straits relations, whoever commands the resources in short supply, like capital, technology and know-how, will prevail in the dependency relationship. From that perspective, Taiwan has lost a golden opportunity of building up the Mainland's dependency on the island by not making the best use of its clear advantage - capital - over the past few decades. Now that capital is no longer in short supply in the Mainland, Mainland's dependency on the island is naturally waning.

Worse, because of the restricted contacts, the Taiwan market is not an attraction to Mainland exporters, unlike many of its neighbours whom are among the Mainland's top customers and command some marketing power. While Taiwan still has some edge in technology, increasingly its comparative advantage is shifting toward its untapped (by Mainland) market. In this respect, proposals to open up Taiwan to investment from the Mainland are significant, as well as is the proposal to allow more Mainland visitors to the island. Aside from the immediate boost from investment dollars and tourist spending, such moves will have a longer term impact. On the one hand, more visitors from the Mainland means better propagation of Taiwan's achievements over the past decades back in the Mainland, improving mutual-understanding and reducing unnecessary enmity. On the other hand, more Mainland investment allows different Mainland groups to build up their interest in the island, which they will need to defend over time.

To some extent, a parallel strategy can be drawn from Hong Kong, which has strong economic linkages with the Mainland, and a highly inter-dependent and intricate relationship with it, but not necessarily a lop-sided dependency relationship. In a broader sense, it is inspiring to look at the experience of post-war Europe, where economic integration has overcome centuries of political rivalry and has led to decades of unprecedented prosperity. The socio-political context of cross-straits relationship may be different, but the prospects are similarly positive.


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