The Hindu Business Line : Rising inflation in emerging markets

Inflation pressures that emerging markets are facing seem much higher than in developed markets. And measures such as subsidies, price controls and export bans can only provide short-term relief at best.

Dr Mark Mobius.

Mark Mobius

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Inflation has been increasing in a number of emerging market economies over the past year. While inflation in developed markets is also rising, the problem is especially acute in emerging markets because food tends to account for a larger proportion of consumer price indexes.

In addition, many countries are working close to full capacity as investment has not kept up with economic growth, thus pushing up wage inflation. In some cases, official statistics may mask the true extent of inflationary pressures. There is evidence that the sharp rise in food and energy prices is also seeping through to core inflation (in other words, inflation excluding food and energy).

The effect of price rises and the official responses have also given rise to concern. Vietnam reported a year-on-year inflation rate of 25 per cent in May, labour strikes have proliferated there, and growth forecasts have been cut. Rising food prices have also become a core problem in China.

Egypt has hiked public sector wages by 30 per cent to head off social unrest. Indonesia is reported to be ready to spend one-fifth of its budget this year on shielding its citizens from energy price increases.

Certainly, the inflation pressures that emerging markets are facing seem much higher than in developed markets. On the surface, such a development is indeed worrying. And measures such as subsidies, price controls and export bans can only produce short-term relief at best (and, in Argentina, have provoked an outright revolt by farmers) and probably just store up long-term problems.

Responsible approach

But, at the same time, we are encouraged by the responsible approach adopted by the authorities in many countries. For example, the Egypt has decided to pay for the state sector’s wage hikes by curtailing tax exemptions for firms operating out of “free zones”, imposing taxes on interest earned from Treasury bills and reducing state fuel subsidies.

Likewise, Indonesia has announced that it will reduce fuel subsidies by 30 per cent, while Taiwan has just decided to abandon them entirely. Malaysia and India have also just decided to cut fuel subsidies. The decision to allow market forces to control the level of demand will go a long way to stabilising these countries’ finances and help direct resources to other parts of their economies.

While moves by central banks to raise interest rates to cool inflation are generally considered bad news for stocks, over the long term we are also encouraged by the increasing credibility that central banks in some countries have acquired in battling price rises — the Reserve Bank of South Africa comes to mind, as does the Bank of Korea and the Central Bank of Chile. This credibility helps ensure the responsibility for dealing with inflation is taken out of politicians’ hands.

It is also important to keep the threat of inflation in context. Policymakers in some emerging markets argue that the spike in inflation is, at least in part, a short-term supply shock in food and energy that will quickly ease as higher prices lead to increased supply. We see merit in such arguments and, while we are quite concerned by recent developments, we do not yet see an inflation “crisis” that threatens the overall attractiveness of the world’s fastest-growing economies.

Rising consumer price inflation in most emerging markets has been a result of higher fuel and food costs. Some of this has resulted from structural or other difficulties — for example, poor animal hygiene contributes to high meat prices just as poor transportation infrastructure contributes to high coal costs.

Fuel subsidies in markets such as China simply bring even higher demand for fuels and defeat the government’s attempts to cool the economy. Central banks and policymakers may want to consider methods other than interest rate increases or foreign exchange controls to fight inflation.

Dollar peg

Some countries have also pegged their currencies to the US dollar. Successive cuts in US interest rates have exacerbated inflation problems in these countries, which were already struggling with over-heating of their economies. How long these pegs remain in place depends on the economy in question and the priority each central bank puts on inflation control.

But, in general, local currency appreciation and higher interest rates should help combat inflation. Nor do we feel that the prospect of currency appreciation will exacerbate the emerging markets’ problems by sucking in more capital, simply because there are a number of emerging-market currencies that are still relatively undervalued.

Equity investors in emerging markets are worried about high inflation partly because of the possible austerity measures governments may implement to cool the economy and partly because of the cost pressure local manufacturers may face as a result of price rises. Another concern is often the depreciating value of future money.

However, other economic indicators should also be considered. For example, a negative real interest rate environment (the case actually in many countries) may be positive for asset prices and beneficial to property developers. Retailers may also benefit as people are discouraged to keep money in the bank but to spend money before it loses its purchasing power.

As much of the recent up-tick in global inflation has been concentrated in commodities, it has helped stock indexes in places such as Latin America and Russia. While commodity prices may come down from their peaks, we do not foresee prices to return to extremely low levels in the near future.

This is in part because of continued demand from emerging markets and relatively inelastic supply. Thus, commodity companies should remain profitable and constitute attractive investment opportunities.

(The author is Executive Chairman, Templeton Asset Management, Ltd.)

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