Asia's inflation trap puts growth at risk
Asia has an inflation problem. The sooner it comes to grips with it, the better. Regrettably, the appropriate sense of urgency is missing.
Willingness to tackle inflation is impeded by Asia's heavy reliance on exports and external demand. Fearful of a relapse of end-market demand in a still-shaky economic recovery, Asian policymakers have been reluctant to take an aggressive stand for price stability. That needs to change - before it is too late.
Excluding Japan, which remains mired in deflation, Asian inflation rose to 5.3 per cent in the 12 months ending last November, up markedly from 3.5 per cent a year earlier. Trends in China and India are especially worrisome.
Sharply rising food prices are boosting headline inflation in Asia. And this is hardly a trivial development for low-income families in the developing world, where the share of foodstuff in household budgets is twice or even triple the ratio in developed nations. At the same time, underlying 'core' inflation, which strips out food and energy prices, has been rising, too. Annual core inflation for Asia (excluding Japan) was running at a 4 per cent rate late last year - up about one percentage point from late 2009.
A key lesson from the high inflation of the 1970s is that central banks cannot afford a false sense of comfort from any dichotomy between headline and core inflation. Spillover effects are inevitable, and once a corrosive increase in inflationary expectations sets in, it becomes all the more painful to unwind. The good news for Asia is that most of the region's monetary authorities are, in fact, tightening policy. The bad news is that they have been generally slow to act.
Financial markets appear to be expecting a good deal more Asian monetary tightening - at least that is the message that can be drawn from sharply appreciating Asian currencies.
Export-led economies, of course, cannot take currency appreciation lightly - it undermines competitiveness and risks eroding the country's share of the global market. It also invites destabilising hot-money capital inflows. Given the tenuous post-crisis climate, with uncertain demand prospects in the world's major markets, Asia finds itself in a classic policy trap, dragging its feet on monetary tightening while risking the negative impact of stronger currencies.
There is only one way out for Asia: a significant increase in real, or inflation-adjusted, policy interest rates. The longer this is deferred, the more wrenching the ultimate policy adjustment, and its consequences for growth and employment, will be.
Much is made of Asia's Teflon-like resilience in an otherwise tough post-crisis climate. Led by China, the high-flying economies of developing Asia are increasingly viewed as the new and powerful engines of a multi-speed world.
While the jury is out on whether there has really been such a seamless transition of global economic leadership, Asia must face up to the critical challenges that may come with this new role. Inflation, if not addressed now, could seriously compromise the region's ability to meet those challenges.
Stephen S. Roach is non-executive chairman of Morgan Stanley Asia and author of The Next Asia