IF FORCED TO choose the single biggest threat to Asian economic stability today, it's fairly certain that regional investors and policy makers would answer with a single voice: "inflation."
For long-term followers of the region, this is a very strange state of affairs in- deed. Unlike its Latin American or Eastern European counterparts, Asia has never suffered from chronic high inflation; with the exception of the immediate aftermath of the 1997 Asian financial crisis, even the worst emerging Asian performers gener ally reported sleepy price一growth rates in the mid single一digit range. And since 2000 the numbers have tended to be downright comatose: less than 1% year一on-year CPI inflation in China, Hong Kong, Singapore and Taiwan in the first half of the decade and only marginally higher in Malaysia, South Korea and Thailand. Only a year or two ago, investors could be forgiven for assuming that inflation was a "dead" issue.
But no longer. As of mid-2008, it's in- creasingly difficult to find Asian countries with consumer price inflation rates of less than 5% year on year. Inflation in China has jumped to 8%, with Singapore, Thai- land and Hong Kong not far behind, and Indonesia, India and the Philippines are already breaking through double一digit rates. Upstream indices of raw material or producer prices are uniformly rising at 10% or more. And most important, the trend continues to be up, up, up in all cas es, with no sign of slowdown in sight.
What on earth is going on? Are five years of rapid growth and loose monetary conditions finally starting to catch up with the region? Or is something else driving price behavior? Is higher inflation an an- noyance, or a major structural shift that requires substantial changes in macro poi icies? And in the worst case scenario, could inflationary pressures prove to be the death knell for Asia's recent long stretch of record growth and stability?
In my view the answer is twofold. First, it seems clear that the days of zero Asian inflation have come to an end, and they are unlikely to return for a very long time ahead; this is in many respects a "normal ization" of price trends, and one that will certainly require policy adjustments along the way. At the same time, however, I am also forced to conclude that the sharp ac celeration in the recent six to 12 months is overdone, driven by a number of tempo- rary factors as well. Going forward, I ex pect to see headline inflation rates stabilize in most cases and perhaps fall outright by 2009. In other words, this is still far from the "disaster scenario" that would bring record regional growth to an abrupt end.
Let's start with the basics. The first point to make is that this is not just an Asian phenomenon; for the past few quar ters inflation has been infecting the entire developing world. Indeed, it's difficult to find a more disturbing picture than the one obtained when we calculate monthly cpi trends for the 50 largest emerging market economies around the globe. As it turns out, consumer一price inflation pres sures were either stable or falling outright from 2000 right through the middle of 2007 and since then there has been a sud den, massive jump in headline inflation. From a comfortable pace of 4.5% just 12 months ago, the average emerging market cpi inflation rate has jumped to more than 10% today.
Needless to say, this has come as a strong shock to both governments and in- ye stors一in particular since inflation measures in the United States, Europe and Japan have not moved by anything close to these magnitudes-and the "inflation question" is now starting to dominate the emerging-market policy debate.
Where is inflation coming from? The short answer is food prices. As shown in the chart nearby, the cri inflation rate for food items in our emerging sample has simply skyrocketed over the past 12 months, from 6% in the middle of 2007 to around 17% today, an unprecedented move by the standards of the last few decades. Meanwhile, although some emerging countries do have very high "core" infla tion rates, the overall average pace of non- food cpi inflation in the 50一country sample has risen only moderately, and was still no more than 6% as of May 2008. Keep in mind that despite all the talk about rising energy costs, the nonfood cri line in the chart below actually includes oil products and electricity; i.e., it's not crude一oil prices pushing the world into an inflationary spiral-it's definitely food.
This, in turn, is a reflection of an eye- popping recent spike in key agricultural goods, and particularly in grains, edible oils and fertilizers. At their peak in the spring of this year, global corn and wheat prices had doubled from levels seen in ear- ly 2007. Asian rice prices are three times higher today than a year ago; palm, soy- bean and coconut oils have nearly tripled as well. And fertilizer prices have simply exploded, with 400% price increases for many categories. All told, this is by far the biggest increase in global agricultural pric es that the world has seen since the 1970s.
Naturally rising food costs hit consum ers everywhere, and this has contributed to higher一than-expected inflation in the U.S., European Union and Japan as well as poorer developing countries. However, the impact on the former group is greatly mod- erated by a couple of factors. To begin with, the share of food in overall consumer expenditure is relatively low, around 15% for industrial countries on average; moreover, much of what wealthy consum ers call "food" is actually labor and other services in the form of supermarket and restaurant rents, packaging, delivery, ad- vertising, etc. By contrast, the food share in Chinese, Indian and Indonesian con- sumer baskets runs between 30% and 40%, and the lion's share of that total is purchased in basic wet markets and con- sumed at home. This helps explains why U.S. and Japanese cri inflation has picked up only gradually-while emerging infla tion rates have soared.
why Food?
SO WHY FOOD? And why now? There are a number of common explanations for the recent price jump. Some are concerned with short-term cyclical shocks that hit global markets in 2007-08: First, a number of food producers experienced poor har vests and weather-related disruptions this season; second, at the same time, financial innovation has pushed record一high amounts of liquidity into commoditized agricultural markets with the creation of new index products and investment funds; third, the resulting price swings were un usually amplified by low grain and other product inventories; and fourth, food ex porters have been quick to respond to price shocks by "hoarding", i.e., hiking export tariffs or and closing borders outright- thus pushing global prices higher still.
So far the list is uncontroversial, but keep in mind that all of the above factors are temporary in nature. With the likeli hood of better harvest conditions in the second half of the year and agricultural exporters such as Vietnam already easing trade restrictions, global food prices could easily stabilize or retreat from the current elevated peaks. And just as financial flows may have added to pressures in recent quarters, speculative funds could inten sify downward swings as well. In the ab sence of other driving forces, these trends would tend to push headline cri inflation down in 2009 as the contribution of food prices fades.
Which brings us to the real issue at hand, and by far the most important ques tion facing investors today: Are emerging markets suffering a painful but temporary jolt-or is this just the beginning of a long- term, sustained rise in global agricultural prices, similar to what we have already seen in crude oil and other mineral com modities?
There are two additional arguments in favor of the view that food prices will in- exorably continue to go up from here. The first is that high oil and energy costs are pulling up grain prices behind them, as biofuel demand diverts a growing amount of farmland away from more traditional uses. And the second is that record eco nomic growth in emerging markets also means record food一consumption growth, with higher incomes and a shift away from basic carbohydrates in favor of meat and milk pushing up caloric intake. On the face of it, the combination of rising costs, lower effective supply and sharply expanding food demand from billions of emerging consumers seemingly amounts to a "per fect storm" for global agriculture.
The problem, however, is that the case for a structural food price boom is far from iron-clad-and as we will see below this is crucial to understanding the nature of current inflation and how policy makers react to it. Mind you, there's little doubt that energy prices can push food costs up; during the first 1973一75 oil shock grain prices rocketed in tandem with global crude, tripling in real terms during the first two years alone. But while oil prices continued to rise for the next decade to come, wheat and corn prices fell back al most immediately, dropping all the way down to pre一1973 levels in the space of a year or so and continuing to decline throughout the 1980s and 1990s. Even if we account for higher substitutability be- tween fossil fuels and agricultural com modities today as a result of biotechnology improvements, there's no theoretical reason to ex pect grain costs to rise au tomatically by anything close to the magnitude of crude price increases; in particular, historical sup- ply elasticities for agricul ture are very different from those in mineral goods. And how to explain the be- havior of an item such as fertilizers, where traded prices have already shot well beyond those for crude oil and other energy products?
The main case for w饰"this time is dif ferent" focuses on the demand side of the equation, and in particular the record- high overall growth pace in populous Asian countries such as China and India. Indeed, for the past five years the key to investing in commodity markets has been very simple: just watch what China buys. As soon as the mainland began to increase its net imports of any product, the price tended to skyrocket; this has been the case with crude oil, bauxite, iron ore, soybeans, palm oil, coal and a host of other products. No surprise, then, that global attention has shifted to the state of Chinese agriculture, where reports of falling land availability and sharply rising urban consumption have fueled interest in food plays as the next hot commodity area. And with do- mestic food prices already surging to un precedented levels since last summer, what more evidence do we need that inter- national agricultural markets are now in the midst of a classic "China shock?"
In reality, however, breathless reports of China's impact on traded food prices are vastly overstated. The mainland is grap pling with its own food-inflation problem, but the main sources of rising prices have been pork, milk, eggs and fresh vegetables 一i.e., a very different set of goods from those plaguing the rest of the emerging world. And if we turn to grain and fertilizers, which have been driving the cur- rent global shock, we find that China is still a stable or even rising net exporter in each case, with domes- tic prices now much lower than the elevated interna tional level (in fact, China is a significant net export- er of agricultural products overall, and the same is true for India).Nor is there any evidence that China will be forced to start buying soon: sown grain acreage fell sharply in the early part of the decade as a result of the 2000一03 real一estate development bub ble, but tighter construction lending, more restrictive land-sale procedures and gov ernment income support have led to a re surgence in grain production in recent years. As a result, mainland corn, rice and wheat stocks stopped falling in 2005 and have been roughly stable since. And the best available data suggest that the big mni- tial surge in milk, meat and other high-ca- loric consumption items is already behind us, with slowing population growth and more measured urbanization ahead.
So while we have little doubt that pop- ulous Asian giants such as China and India will eventually move toward a net agricultural import position, this is certainly not the case today.
What to Do?
TAKEN TOGETHER, THE above points high- light some of the profound uncertainties about nature and sustainability of the cur- rent inflation shock. There's no question that emerging consumers are feeling pain today over rising food costs, and that gov ernments have seen a marked and sudden shift in the headline price environment- but again, this doesn't necessarily mean that there's an even greater global agricul tural cost explosion to come. Put yourself in the average emerging policy maker's shoes for a moment and consider the fol lowing two scenarios.
In the first, traded grain and fertilizer prices stabilize in the second half of 2008 or even pull back somewhat from current levels. Here, food cpi inflation would fall sharply down to a low single一digit pace by early next year from 16% to 18% year一on- year rates of today (and at risk of repeating ourselves, we don't actually need to see food prices fall; as long as they are not tni- pling again from today's levels, food infla tion will automatically come o均.Because food costs are still high in level terms, there would still be pressure on low-end wages and thus on other goods and ser vices prices as well, i.e., "core" inflation would continue to pick up in the near term. But since virtually all of the recent emerg ing cri jump came from food alone, overall headline inflation would naturally decel erate considerably, making 2009 look a lot less onerous than 2008.
Alternatively, agricultural commodity prices could continue to skyrocket for the next 12 to 24 months, holding food inflation at current levels and potentially push- ing headline cri price growth up even further. In this scenario, core inflation would also begin to increase at a faster pace, raising the risk that the macro shock would escalate from a painful relative price adjustment to an even more onerous and entrenched broad一based inflation problem-similar to what the developed world experienced in the 1970s.
What is the optimal response? If you just assume that "it's all food" and do noth ing, you run the risk of waking up in 12 or 18 months' time with a more serious infla tionary scare on your hands. But if you as- sume the worst and undertake Draconian tightening measures now, you will be ag gressively choking off economic activity in the face of an external shock that clearly seems to have temporary elements. To a large degree, the "right" choice is to do precisely what most emerging policy mak ers have done over the past six months: be cautious at first, wait to see how things develop, and then tighten only gradually in line with wage and nonfood "core" infla tion pressures.
At this point, many readers will be tempted to protest strongly; how can we say that developing countries are making good policy decisions when it's precisely the combination of overheated growth, misguided currency pegs and excessively loose emerging market liquidity conditions that got us in this mess in the first place? Aren't emerging central banks disastrous- ly "behind the curve," and won't policy makers everywhere have to take much more aggressive action to slow the global commodity inflation juggernaut down?
This is a very common contention, but it doesn't completely hold up to the evi dence. There's little doubt that Chinese and Asian growth have played a significant role in pushing up fuel and mineral prices, but as we saw above, emerging markets ev erywhere were doing a perfectly adequate job of managing commodity inflation until food prices hit the scene (and despite the popular view, energy cost pressures have not been held back by subsidies and price controls for the most part; the number of emerging countries actually subsidizing fuel prices is much smaller than generally assumed).
And as discussed earlier, while crude oil and mineral costs do help push up grain and other agricultural prices, this doesn't mean that grain prices have to double or triple again from current levels一and it may not even prevent a subsequent food price decline.
Looking at economic growth, there's no doubt that the emerging world is ex panding at the fastest pace in decades, close to 7% in real terms by my best mea sure, and in the past few years we have seen a robust pickup in investment spend- ing as a share of GDP. Real policy interest rates have also been on the low side since 2001, i.e., there is clear support for policy tightening without having to worry about derailing "fragile" recoveries.
On the other hand, however, emerging monetary data do not exactly point to a problem. Overall M2 growth has visibly picked up since 2004 (see chart on page 24), but very much in line with the acceleration in real growth; in other words, there's no strong indication that excessive money creation is the main driver of cur- rent headline inflation trends, and we are still light years away from the饰perinfla tionary environment of the 1980s and ear- ly 1990s.Nor is the starting point for inflation very high; for the past 10 years emerging markets have enjoyed the lowest average cri inflation on historical record, and even in today's "scare" conditions the average core inflation rate is still far below the pace of 20 years ago, with plenty of room to increase in most economies before we reach historical concern levels.
And finally, to stress the point made above, if excessively high growth in the emerging world is behind food prices, then why don't we see the fastest-growing and most populous developing countries actu ally increasing net food purchases on a sustained basis?
The bottom line, as I see it, is that infla tion in Asia and the rest of the emerging universe is nowhere near the "disaster" stage, nor is it yet reaching a level that would credibly threaten growth prospects going forward. Of course there's no guar antee that we won't get there, particularly if food prices continue to skyrocket from here and force up wage and other costs along the way-but in my view there's an equally good if not better chance that the current wave will pass over the next year or two.
.bmp)
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