Bill Emmott - International Author & Adviser


Inflation in the emerging markets
Exame - June 2008

In what feels like the blink of an eye, the emerging markets have been transformed from being global agents of deflation to becoming the sources of a new wave of inflation all around the world.  The transmission mechanism for this transformation is the price of oil and, to a lesser extent, food, both driven higher by strong demand in China and elsewhere. In reality, though, the ultimate means by which inflationary pressure is being transmitted across borders is an even more fundamental commodity: money.

                Excess liquidity in countries ranging from China to Russia, from India to Saudi Arabia has pushed inflation rates higher all over the world. Now that it is happening, it doesn’t seem a surprise. Yet when the developed countries’ credit crunch began in August last year, deflation looked a greater danger: the abundant savings in emerging markets offered a crucial hope that a deflationary spiral could be avoided.

As subprime mortgage losses mounted, contributing to wider losses from complex securities mainly held by American and European banks, the danger was that bank lending would start to shrink, threatening a vicious cycle of bankruptcies, further losses and then further tightening of loan conditions. Injections of capital from Asian and Arab funds directly into Western banks helped to prevent such a cycle from getting going. Import demand and continued infrastructure investment in Asia and the Arab Gulf promised to help support global trade and with it wider economic activity.

So far, the first part of this dream has come true: there is no sign of deflation in America or Western Europe and the credit contraction has not become vicious, troubled though the banking sector may be. Measured simply by GDP growth rates, the second part also continued to look plausible: global growth has slowed from the fast rate of more than 4.5% that was seen in 2006-07, but so far only to about 4.3%. That is far from disastrous. Yet what may yet prove disastrous are the inflationary consequences of this glut of Asian and Arab capital.

                Inflation has accelerated in the past year from 3% to 7.7% in China, from 7.8% to 15% in Russia, from 6.7% to 8.7% in India, from 2.9% to 10.5% in Saudi Arabia and even from 3% to 5% in Brazil. Part of the problem has arisen because of low American interest rates: cuts by the Federal Reserve have been followed by central banks in many of these emerging markets, or else such banks have left their interest rates unchanged when they should have been raising them in order to reduce money-supply growth.

 That, though, is really just a way of saying that the problem has arisen because of currency policies.  In order to control the exchange rate against the dollar, central banks have kept interest rates low and have added to their foreign exchange reserves by buying dollars or euros, allowing some of the inflow to boost the domestic money supply. That is not so true of Brazil, where the Real has climbed steadily against the dollar, but it is true of China, where the Renminbi has risen only gently against the dollar and has actually fallen in value against the Euro in the past year.


China in the inflationary spotlight

In all of those countries where rapid economic growth has coincided with a surge in inflation, the central bank needs urgently to tighten monetary policy by raising interest rates. If it doesn’t, then wages are likely to start spiralling upwards too, making inflation worse and making the eventual remedy for it even more painful when it comes. That was what happened in America and Western Europe in the 1970s when oil shocks and rapid inflation were simply accommodated by central bankers, and sometimes reinforced by fiscal laxity, rather than being responded to firmly through tighter monetary control.

                Some countries’ central banks will no doubt act toughly, as the Fed’s Paul Volcker did in the early 1980s, while others will be lax, hoping the problem will go away of its own accord. From a global point of view, however, one country’s central bank is more important than all the others. That is China.

                The reason for China’s special importance divides into two parts. One is that China is now the developing world’s biggest economy by far, being now the world’s fourth largest overall, and one of the most open to trade.  That means that its economic performance has a big effect on other economies. The other reason, though, is that Chinese liquidity and the rapid, resource-intensive growth of the Chinese economy in the past five years has played a vital role in encouraging the prices of oil and other commodities to rise in price. In many commodities, China has accounted for 30-50% of the rise in demand seen in the past several years.

                If Chinese demand for oil continues to grow strongly, then the oil price is likely to carry on rising, marching as some say towards $200, intensifying the inflationary pressure around the globe. But if the Peoples Bank of China, the country’s central bank, were to raise interest rates sharply (which are currently well below the rate of inflation), bank lending growth would be cut and the economy would slow, cutting also the rate of growth of China’s demand for oil.

                The only way in which this could be achieved would be for the PBOC to allow the Renminbi to appreciate much more rapidly against the dollar and the euro, ceasing its purchases of foreign currencies. Initially, such an appreciation might act as an incentive for even more inflows of capital, as speculative firms placed a bet on further appreciation. Consequently, it may well be that a revaluation of 20% or more on a trade-weighted basis might be necessary to stabilise capital flows.

                The terrible earthquake in May in southern China, which claimed more than 70,000 lives, has made the Chinese government extremely concerned about political instability. It feels hyper-sensitive about any sort of criticism or any threat of unrest. With the Beijing Olympics due to take place in August, this is not a time nor an atmosphere likely to be conducive to the implementation of drastic monetary and currency measures.

For that reason, some analysts suspect the announcement in June of a slowing of the annual inflation rate from 8.5% to 7.7% may have reflected political manipulation of the data, in order to buy time. As a result, the pressure on oil prices and on inflation all around the globe is likely to remain uncomfortably strong at least until after the Chinese summer—and the Olympics—have passed. In China’s autumn season, however, the government’s nerve might well return. Inflation needs to be defeated.


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