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Asia's inflation becomes the world's problem

HONG KONG - Asia cemented its status as the 21st Century workshop of the world by exporting the goods global consumers loved at prices that kept falling. Now it's producing the one thing the world hates -- inflation.

Higher prices from the world's factory floor have major implications for a global economy still reeling from the credit crisis and increasingly dependent on Asian exports.

And while regional central banks are reluctantly reversing pro-growth policies that promoted tightly managed currencies, negative real interest rates and fuel subsidies, the damage has been done.

"Not just Asia, but most emerging markets have been in denial about inflation and it will take a lot of interest rate tightening to catch up with the inflation reality," Anthony Chan, Asian sovereign strategist with AllianceBernstein in Hong Kong, told Reuters.

"Will higher interest rates curb demand in Asia and slow the global economy? The risk is there for 2009," he said.

Developing Asian economies -- which account for around 10 percent of global GDP -- will likely continue to act in slow motion to stop inflation and in the meantime will pass along cost pressures to the rest of the world, delaying a recovery in the slowing world economy, economists reckon.

That's a problem as global inflation gathers steam, especially as Asia's breakneck economic development is now being blamed for years of heavy demand for the raw materials that has pushed up global oil prices by more than 300 percent since 2003 and hauled the cost of most industrial commodities with them.

Meanwhile the wealth and demand that development has created are expected to drive average consumer inflation in emerging Asia this year to a 10-year peak of 5.91 percent, according to the International Monetary Fund.

So while U.S. demand for China's exports has dropped in the last year, prices of those goods have actually risen.

The three-month average of growth in Chinese exports to the United States has fallen to an annual rate of 3.5 percent in April, down sharply from 16.9 percent 12 months ago.

However, the annual rise in import prices of Chinese goods was running at 4.31 percent in April, compared with a decline of 0.3 percent in April 2007.

Inflation scourge

Inflation has become a scourge in Asia, fomenting worker strikes, forcing governments in China and India to lift energy subsidies and mowing down regional stock markets by 25 percent in the last eight months, according to the MSCI index of Asia Pacific shares outside of Japan .MIAPJ0000PUS.

China, the world's most dynamic economy, raised gasoline and diesel prices by around 17 percent last week, a move that could ultimately raise consumer inflation by a manageable one percentage point this year, economists said.

Still, Chan said China's attempts to control price pressures and growth of its money supply have been reactive and unsuccessful at rooting out the causes of inflation.

For example, rather than trying to change expectations about the yuan appreciating, which many analysts say is behind the speculative "hot money" finding its way into the country, Beijing continues to tightly manage the yuan's exchange rate.

In the last 12 months, the yuan has risen around 10 percent against the U.S. dollar CNYCFXS. On a broader real effective trade-weighted basis, the yuan has gained only 7.2 percent.

Still too accommodative

Outside of Japan, other major Asian economies like Taiwan, India, Indonesia, the Philippines and Vietnam have already started to tighten monetary policy. However, the entire region has some distance to cover.

Research from Citigroup showed that globally only in the United States, where fears of a recession are still potent, are real interest rates lower than emerging Asia's.

Economist say the focus of the region's policymakers on protecting high growth and jobs can easily backfire if they wait too long to curb inflation.

"History shows that the policy reaction would then need to be much stronger and growth would also need to slow much more to bring inflation back down, which would create a much more challenging environment for global growth and the equity markets in the region," said analysts with Credit Suisse Private Bank in a note to clients.

V. Anantha-Nageswaren, chief investment officer, Asia Pacific for Bank Julius Baer in Singapore, said low interest were no longer supporting share and bond markets.

On the contrary, dwindling confidence in policymakers' ability to contain inflation was prompting investors to sell equities and push up longer maturity bond yields.

Indeed, 10-year Chinese government bonds were auctioned last week with a yield of 4.41 percent, much higher than market forecasts of about 4.33 percent.

"We have well crossed the point where the loose policy framework supports asset prices and growth. Actually, they have become adverse for equity and capital markets in Asia," said Anantha-Nageswaren, who recommends investors hold up to 17 percent of their portfolios in cash.

Even after fuel subsidies were lifted in China, India, Indonesia, Malaysia, Sri Lanka and Taiwan, oil prices are still above $130 a barrel CLc1 and gold, which is often used as a hedge against inflation, is near $900 an ounce XAU.

Anantha-Nageswaren said in order for oil prices to fall significantly -- defusing one of the biggest risks to the global economy -- there needs to be a material slowdown in Asia along with a decreased dependence on exports.

However, central banks remain reluctant to take more drastic measures to dash inflation before higher prices become embedded in public expectations.

"At this point, if Asia did not do it in the last five years, they won't do it now," he said. "If they don't do it voluntarily, commodities prices rising to such high levels will automatically do their job."