The sharp rises in food and energy prices have led to inflation rising globally. The impact on Asia, as with other Emerging Economies, is however more intense as food and energy make up a large component of the consumer price index. Furthermore, Asian economies have generally been growing above their trend levels and second round effects are emerging, i.e., prices are also rising in other areas apart from food and energy. By contrast, the current slowdown in the developed economies is reducing the pass-through effect of higher energy and food prices.

The actual impact of commodity prices on inflation in the individual Asian economies depends on how important food and energy are in the respective consumption baskets and also on the extent of subsidies.

Policymakers in Asia are compelled to respond strongly to the inflation problem in Asia, but responses have differed significantly. Broadly speaking, there have been two main kinds of policy:

• Raising of interest rates.

Countries with rising inflation and trade deficits are facing capital outflows and this has led to a weakening of their currencies and even more inflationary pressures. Central banks in these countries have had to hike interest rates (Vietnam, Indonesia and the Philippines) or are likely to do so very soon (Thailand) to prevent their currencies from depreciating too drastically. Vietnam's policy interest rate was sharply raised from 8.5 per cent to 12.5 per cent recently, while Indonesia recently hiked interest rates by 25bps. The Philippines, where inflation is now 9.6 per cent, hiked interest rates by 25bps to 5.25 per cent today and it is likely that we will soon also see interest rate hikes in Thailand, where inflation has reached 7.5 per cent.

 

India has also tightened monetary policy further but through the raising the cash reserve ratio rather than raising the overnight rate. Until recently, the Korean Central Bank was expected to lower interest rates but it is now expected to keep rates on hold.

• Currency appreciation.

Countries with strong trade surpluses are allowing their currencies to appreciate to mitigate inflation pressures. The Monetary Authority of Singapore re-centred the Singapore dollar early in April i.e. revaluing the trade-weighted currency upwards. The Malaysian dollar closely tracks the Singapore dollar and the currency has also moved upwards in tandem. For China and Taiwan, the renmimbi and Taiwan dollar have also been appreciating. China has a very strong trade position and structurally the renminbi is on the ascent, while Taiwan is benefiting from a repatriation of capital following the Kuomintang's election victory in March. China has been tightening monetary policy through raising the banks' reserve requirement ratio. The latest hike came last week, to 17.5 per cent. The Taiwan central bank recently hiked policy rates by 25bps but interest rates have been extremely low because of the weak economy.

Food and energy are heavily subsidized in many Asian economies. The recent surge in oil prices to over US$130/bbl is causing acute problems for some countries as a continuation of subsidies is a severe drain on the government's fiscal position. The immediate effect of reducing subsidies is however to send inflation rocketing up which, apart from the effect on the economy, also jeopardizes social stability. Again, Asian governments have differed in their response.

• Reducing subsidies.

In Taiwan, domestic fuel prices were recently hiked by 13 per cent while electricity prices were hiked 27 per cent. Subsidies are estimated to be around 0.4 per cent of GDP. The Taiwan government has however maintained its full-year inflation target of 3.08 per cent and to achieve this, interest rates are likely to be raised. In Indonesia fuel prices were hiked by around 30 per cent at the end of May and Bank Indonesia raised its interest rate by 25bps at its monetary policy meeting on 5 June 2008. Fuel subsidies account for an estimated 3 per cent of Indonesia's GDP. The government in Malaysia is also reconsidering its fuel subsidy programme, and has just announced a 41 per cent hike on petrol prices while electricity tariffs will be hiked 18-26 per cent. At the last central bank policy meeting, the central bank indicated that it may tighten policy if fuel subsidies are removed and inflation rises. We estimate that the removal of subsidies will lead to inflation rising from the current 3 per cent to about 6 per cent. Fuel subsidies account for 7 per cent of Malaysia's GDP. India has also just raised petrol and diesel prices by 10 per cent. Cooking fuel has also been raised, by 17 per cent. Government fuel subsidies are currently US$7 trillion, or 0.6 per cent of India's GDP.

• Maintaining subsidies.

In China, pump prices for petrol, diesel and jet fuel were raised in November 2007 but prices are still below international prices. In the Philippines, there are few signs that subsidies will be reduced. The central bank has however indicated that the policy interest rate may be raised if inflation breaches its 2009 target of 3 per cent -5 per cent. Until recently, the central bank had emphasized the downside risk to growth rather than the risks of inflation. In Thailand, the government, who is facing some political tension, is reintroducing subsidies and the new subsidies will potentially run for six months.

• There are no direct fuel or food subsidies in Korea and Singapore.

The Korean government has however instituted a price freeze on electricity for the second half of 2008, with the burden being borne by the state owned electricity board, KEPCO. Singapore provides cash rebates to the needy sections of the population.

An ironic point about high oil prices is that oil prices have been rising despite the fears of a U.S. recession and the slowing global economy because demand has been kept artificially high through subsidies. Asia's strongly growing economies and fuel subsidies have contributed in no small part to the resilience of global oil demand.

Investors are likely to favour economies where inflation pressure can be contained through the appreciation of currencies and which need only modest interest rate hikes, compared to the economies where policymakers can do little by way of appreciating their currencies and have to rely solely on sharp hikes in interest rate both to control inflation as well as to protect their currencies. In this respect, the Chinese renminbi, the Taiwan dollar, the Singapore dollar and the Malaysian ringgit are likely to continue outperforming in the coming months.

In Vietnam, the risk has grown such that the situation could become unstable. Rising inflation is fuelling capital outflows, which has severely weakened the currency, which adds further to inflation, now raging at 25 per cent. Without a strong policy response, there is a chance that a crisis could develop and necessitate an intervention by the IMF. The forward market is pricing the 1-year USD/VND at 22000, i.e. the market expects the currency to depreciate by nearly 30 per cent within the next 12 months. Vietnam's 5-year sovereign debt credit default swaps spread have also widened significantly in recent days, indicating an increase in the risk of Vietnam defaulting on its external debt. Although Vietnam is a small market for investors, there are concerns that a contagion effect could arise and affect the economies which face a similar set of problems, for example Indonesia.

Forecasting inflation is extremely difficult in the current environment because of highly volatile commodity prices. In Asia, the arbitrary nature of food and energy subsidies compound the problem of gauging inflation pressures. Assuming that oil prices do not rise further, inflation in Asia is likely to continue to rise in the near term, as the base effects of the recent spikes in food and energy prices will only wear off in 2009. But the kind of acceleration we have seen in recent months is not likely to continue and the pace should taper off as we move through 2008.

We expect inflation pressures to be strongest in the countries where producer prices are diverging from consumer prices. Sharp divergences indicate that inflationary pressures are building and likely to emerge at some point.

Moderate inflation is positive for equities, as it is a sign of strong aggregate demand, which is positive for corporate earnings. Moreover, equities are also a hedge against inflation, since they represent a claim on income generated by real assets.

The danger arises when inflation gets out of hand and monetary authorities need to tighten policy drastically to rein it in at the expense of growth. We have seen an extreme example in the case of Vietnam, with inflation exceeding 25 per cent and the central bank hiking rates from 8.75 per cent to 12 per cent at one go.

The government also cut its forecast of 2008 GDP growth to 7 per cent from 8.5 per cent. As mentioned, other Asian economies like Indonesia, Philippines, India and possibly Thailand face similar pressures and are therefore, also vulnerable to sharp monetary tightening.

As inflation could become the dominant theme in the second half of 2008, it is a key factor in shaping our investment strategy.

• Prefer markets where inflation will remain moderate or where the central bank will not act aggressively

Taiwan has less inflation worries than other markets while Korea's central bank is likely to stay on hold although there is some inflation pressure. Hong Kong, without a true central bank, with its currency pegged to the US dollar, is a clear beneficiary in the current situation.

As the Fed funds rate is likely to stay low for the coming months, so will short term rates in Hong Kong. Something similar is true of Singapore. The central bank policy targets currency appreciation, instead of interest rate hikes to control inflation. The strong Singapore dollar has attracted strong liquidity inflows which has kept interest rates low. The resulting negative real rates are a positive boost for asset prices.

• Underweight markets vulnerable to accelerating inflation

We are less sanguine on the Philippines, Indonesia and India markets, where inflation has already risen above 10 per cent or could rise above 10 per cent and the authorities are likely to have to take drastic measures. We are also underweight Malaysia as the recent removal of fuel subsidies is likely to lead to a near term spike in inflation and this has increased political risk. Bank Negara though is not expected to have to tighten drastically.

• Cautious on countries bearing the burden of fuel subsidies

Rising oil prices have significantly increased the burden of fuel subsidies. This is not an issue for Singapore, Hong Kong and The Philippines where fuel subsidies are absent. China's fuel subsidy is currently less than 1% of GDP, and they are enjoying a healthy fiscal surplus, so they are able to continue the status quo. More pain will be felt in Indonesia and India who have rising fiscal and current account deficits as a result of rising fuel imports and higher subsidies. Indonesia has started taking the painful but necessary step of lifting fuel subsidies further, at the cost of short term higher inflation and social unrest. India's current account and fiscal deficits are swelling, causing the rupee to weaken, resulting in a negative vicious cycle. India has just announced a 10% hike on petrol prices but due to the impending elections early next year, further hikes, if any, are likely to be modest.

• Play the agricultural theme

Although the supply response for food will be quicker than for minerals like oil, the tight situation could last another year or two, due to dwindling arable land and unpredictable bad weather. We have exposure to:

- Plantation owners, preferring Indonesian companies to Malaysians ones as the latter face a new windfall tax

- Companies that benefit as farmers rush to increase food production to benefit from higher prices, e.g. fertiliser producers, tractor makers.

- Beneficiaries from increased rural spending power, for example, mobile phone companies, small town retailers.

• Mindful of margin compression

Companies that are exposed to higher raw material prices are vulnerable to margin compression, especially if slower sales growth erodes their ability to pass on cost increases.

Examples include electronics manufacturers, petrochemicals and automakers.

• Focus on companies with pricing power

Companies with pricing power either because of their strong brands or constraints on supply growth will be able to offset cost increases by raising prices. Examples include branded shoe and apparel makers, and specialist retailers.

• Cautious on companies with government imposed price controls

Some governments will respond to rising inflation by trying to control retail prices for oil, energy, food and other household necessities. Examples include Chinese oil refiners, power companies and food retailers.

• Overweight Japan

The equity market which has strongly benefited from the rise in inflation is Japan, with TOPIX strongly outperforming even Emerging Markets in recent weeks. The latest inflation data released show that inflation in Tokyo, excluding food and energy, is positive. The emergence of Japan out of deflation would enable the Bank of Japan to normalise interest rates and this would boost the earnings of Japanese banks.

Source: Goldman Sachs Asia Economics Analyst, 2 June 2008

Source: Goldman Sachs Asia Economics Flash 3 June 2008