Crouching tiger or hidden dragon?
The West's inflation difficulties are nothing compared with the problems now facing many of the so-called "emerging" economies. China now has an inflation rate of 7.1 per cent. Saudi Arabia's inflation rate is 9 per cent and Russia's stands at 11.9 per...
The West's inflation difficulties are nothing compared with the problems now facing many of the so-called "emerging" economies. China now has an inflation rate of 7.1 per cent. Saudi Arabia's inflation rate is 9 per cent and Russia's stands at 11.9 per cent. Argentina's inflation rate is, officially, a more modest 8.2 per cent, although many people, including those who work at the IMF, think the true inflation rate is a lot higher.
Apart from Argentina's rather dubious claims, these numbers are all a lot more elevated than they used to be. China's experience is grabbing the most headlines. In 2006, inflation was only 1.5 per cent, Saudi Arabia's inflation rate was a touch higher, at 2.3 per cent, but hardly at a level to cause panic within the central banking community. What has gone wrong? Why are the emerging economies' inflation rates now so high? And what do they mean for developed economies?
Broadly, there are two competing explanations for the rise in emerging market inflation. Those living in emerging markets have, on average, lower per capita incomes than those in the developed world. Proportionately, more of their income is spent on basic items such as fuel and food. The prices of these "basics" tend to be volatile in response to bad harvests, occasional wars or the onset of disease. As a result, inflation rates within emerging economies move up and down a lot more than their equivalents in the developed world. High inflation in one year could easily be followed by low inflation the next.
The second explanation is monetary in nature. Inflation is rising because monetary conditions are simply too loose. And because people in emerging markets spend most of their income on basics, it is no great surprise that the prices of fuel, food and other essentials go up.
This debate is a throwback to the 1970s when, inflation in the western world was all the rage. Back then, neither economists nor anyone else could convince themselves that inflation was a monetary phenomenon. Many thought that inflation had nothing to do with money. Instead, it was going up because of high oil prices, wage pressures and big price increases.
This approach led to all sorts of, by now, well-documented problems. Monetary policy was aimed not at the control of inflation but, instead, at the achievement of maximum growth. To keep inflation in check, governments were forced to use incomes policies, price controls, voluntary wage restraints and other market-distorting techniques. This, though, was a bit of a disaster. The controls would not stick. Those with industrial muscle managed to push through wage and price increases. Meanwhile, market mechanisms broke down. The invisible hand went missing and economic growth fell flat on its face.
Now back to the present day. Many emerging market policy makers have deliberately controlled the value of their exchange rates in recent years, particularly vis-Ã -vis the dollar. Partly, they did this for good, old-fashioned, mercantilist reasons, based on the traditional Asian model of export-led growth. They have also, though, shadowed the dollar in an attempt to free ride over the Federal Reserve's anti-inflation credibility.
The problem with this approach, however, is its failure to deal with underlying economic realities. Fast-developing economies cannot help but experience upward pressure on their exchange rates. As they become more productive, so their buying power over foreign goods improves. In other words, their terms of trade get better. A rising exchange rate secures this outcome by making foreign imports cheaper.
What, though, if the authorities prevent the nominal exchange rate from rising? In these circumstances, the only other option, ultimately, is a rise in the so-called real exchange rate via a higher domestic inflation rate relative to inflation rates in other countries. Imports will then become cheaper and cheaper.
This outcome, though, presents two difficulties. The first one is a problem for the emerging world. By preventing their exchange rates from rising, emerging economies will inevitably experience rising inflation. However, rising inflation can easily lead to an unfair redistribution of income and the associated social tensions can easily lead to political turmoil. Inevitably, politicians try to prevent this by imposing price and wage controls but then, of course, they are heading straight back to the 1970s.
The second difficulty is for the rest of the developed economies. With inflation rising - and, hence, emerging economies wages rising relative to wages in the developed world - the emerging economies' buying power is on the rise. That means the rest of the world has to pay more for energy, food and countless other items. These higher prices all add to price pressures and help to explain why, even in the midst of a nasty credit crunch, inflation has yet to subside.
This, in turn, means we are facing a much more difficult economic landscape. Even if growth slows a bit, there is no guarantee that inflation will come down particularly quickly. Indeed, higher inflation is part of the process of economic retrenchment. If the developed world ends up paying more for raw materials, yet workers are unable to achieve compensating pay increases, spending power will dwindle. Inflation made in the emerging world is increasingly having an impact on the economic well-being of the developed world.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Apart from Argentina's rather dubious claims, these numbers are all a lot more elevated than they used to be. China's experience is grabbing the most headlines. In 2006, inflation was only 1.5 per cent, Saudi Arabia's inflation rate was a touch higher, at 2.3 per cent, but hardly at a level to cause panic within the central banking community. What has gone wrong? Why are the emerging economies' inflation rates now so high? And what do they mean for developed economies?
Broadly, there are two competing explanations for the rise in emerging market inflation. Those living in emerging markets have, on average, lower per capita incomes than those in the developed world. Proportionately, more of their income is spent on basic items such as fuel and food. The prices of these "basics" tend to be volatile in response to bad harvests, occasional wars or the onset of disease. As a result, inflation rates within emerging economies move up and down a lot more than their equivalents in the developed world. High inflation in one year could easily be followed by low inflation the next.
The second explanation is monetary in nature. Inflation is rising because monetary conditions are simply too loose. And because people in emerging markets spend most of their income on basics, it is no great surprise that the prices of fuel, food and other essentials go up.
This debate is a throwback to the 1970s when, inflation in the western world was all the rage. Back then, neither economists nor anyone else could convince themselves that inflation was a monetary phenomenon. Many thought that inflation had nothing to do with money. Instead, it was going up because of high oil prices, wage pressures and big price increases.
This approach led to all sorts of, by now, well-documented problems. Monetary policy was aimed not at the control of inflation but, instead, at the achievement of maximum growth. To keep inflation in check, governments were forced to use incomes policies, price controls, voluntary wage restraints and other market-distorting techniques. This, though, was a bit of a disaster. The controls would not stick. Those with industrial muscle managed to push through wage and price increases. Meanwhile, market mechanisms broke down. The invisible hand went missing and economic growth fell flat on its face.
Now back to the present day. Many emerging market policy makers have deliberately controlled the value of their exchange rates in recent years, particularly vis-Ã -vis the dollar. Partly, they did this for good, old-fashioned, mercantilist reasons, based on the traditional Asian model of export-led growth. They have also, though, shadowed the dollar in an attempt to free ride over the Federal Reserve's anti-inflation credibility.
The problem with this approach, however, is its failure to deal with underlying economic realities. Fast-developing economies cannot help but experience upward pressure on their exchange rates. As they become more productive, so their buying power over foreign goods improves. In other words, their terms of trade get better. A rising exchange rate secures this outcome by making foreign imports cheaper.
What, though, if the authorities prevent the nominal exchange rate from rising? In these circumstances, the only other option, ultimately, is a rise in the so-called real exchange rate via a higher domestic inflation rate relative to inflation rates in other countries. Imports will then become cheaper and cheaper.
This outcome, though, presents two difficulties. The first one is a problem for the emerging world. By preventing their exchange rates from rising, emerging economies will inevitably experience rising inflation. However, rising inflation can easily lead to an unfair redistribution of income and the associated social tensions can easily lead to political turmoil. Inevitably, politicians try to prevent this by imposing price and wage controls but then, of course, they are heading straight back to the 1970s.
The second difficulty is for the rest of the developed economies. With inflation rising - and, hence, emerging economies wages rising relative to wages in the developed world - the emerging economies' buying power is on the rise. That means the rest of the world has to pay more for energy, food and countless other items. These higher prices all add to price pressures and help to explain why, even in the midst of a nasty credit crunch, inflation has yet to subside.
This, in turn, means we are facing a much more difficult economic landscape. Even if growth slows a bit, there is no guarantee that inflation will come down particularly quickly. Indeed, higher inflation is part of the process of economic retrenchment. If the developed world ends up paying more for raw materials, yet workers are unable to achieve compensating pay increases, spending power will dwindle. Inflation made in the emerging world is increasingly having an impact on the economic well-being of the developed world.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.