Rising Inflation A Major Risk In Emerging Markets: Economist

Source : The Business Times, October 31, 2007

Currencies, property, stocks may become more attractive than debt for investors

Rising price inflation is fast becoming a major risk in emerging markets around the world due to surging food, oil and asset prices, according to a senior economist.

On the rise: Rising food and fuel prices are sending inflation higher in most emerging economies.

For investors, the inflationary pressures building up in these countries and the likely response of central banks means that emerging market currencies, equities, property and commodities are likely to become more attractive than debt - the traditionally favoured emerging market investment, Philip Poole, HSBC's chief emerging markets economist, said recently.

Investment in new production capacity 'has not kept pace' with the recent rapid growth seen in most emerging economies, he said.

As a result, countries such as India - which now has very little spare productive capacity according to some estimates - are likely to experience increasingly severe price inflation as their economies continue to expand.

Elsewhere too, spare productive capacity has been falling, adding to inflationary pressures, except in China where investment in building more capacity has been consistently high, he said.

Food prices, traditionally accorded a high weight in consumer price inflation measures, have also surged due to unstable weather patterns, stronger demand from a growing middle class and a shift in land use away from agriculture to biofuels due to soaring oil prices, he said.

The combination of rising food and fuel prices is sending inflation higher in most emerging economies, he said.

He expects governments and central banks in these countries to step up their fight against inflation in the coming months, using a mix of policy tools, including allowing their domestic currencies to strengthen against the US dollar.

Part of the inflationary pressure build-up has been due to the actions of central banks themselves, he said.

When central banks intervene in financial markets to keep their domestic currencies low in order to maintain the competitiveness of their labour market and exports relative to their peers, they often do this by printing more local currency to buy foreign currencies such as the US dollar.

The new money then gets channelled into domestic assets such as property, contributing to price increases in these assets instead of the currency itself, he said.

The main anti-inflation policy tool employed by developed economies such as the United States and the European Union - raising interest rate targets to discourage borrowing - may not work for emerging economies, he said.

'In an environment where you have open capital accounts and excess liquidity . . . it can be counter-productive to raise rates', as this makes the local currency even more attractive relative to the US dollar, prompting a greater inflow of funds and raising inflationary pressure on the local economy, he said.

Instead, he expects to see central banks employ a broader range of tools to combat inflation, such as raising the regulatory reserve requirements of banks as China did recently - 'effectively a tax on the private banking system' - and allowing their domestic currencies to strengthen against the US dollar. A stronger local currency makes imports cheaper, which helps moderate price inflation.

As a result, Mr Poole believes investors in emerging market currencies, stocks, commodities and property stand to benefit from the inflationary pressures and the likely policy response in the near future.

Just this month, the Monetary Authority of Singapore said it would allow the Singdollar to strengthen at a slightly faster pace than before to cap inflationary pressures, while maintaining its long-standing official policy of allowing a 'modest and gradual appreciation' of the currency.