In October, both the Asian Development Bank (ADB) and the International Monetary Fund (IMF) came up with their updates for the Regional Asian Economic Outlook for the current year and for 2011. For the most part, both of them painted a rosy picture of the economic growth outlook in the region. Just some numbers to illustrate:
ADB expects China’s growth rate to be 9.6% this year and 9.1% next year. India’s growth rate is projected at 8.5% this year and 8.7% next. IMF appears bolder. It projects a growth rate of 10.5% for China in 2010 and 9.6% in 2011. For India, it projects a growth rate of 9.7% in 2010 (2010-11) and 8.4% in 2011 (2011-12).
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It was not easy to locate inflation forecasts from IMF, but ADB has a benign inflation outcome in its forecasts for 2011 and estimates for this year. For instance, China’s inflation forecast is 3.2% this year and next and that of South Korea 3.0% for both the years. Based on current inflation trends and trends in the prices of commodities, these forecasts look likely to be exceeded.
The blame for this current and likely rise in the cost of living must rest with both the US and policy pusillanimity in the region. In his blog post on 10 November, Prof. James Hamilton says that there is little doubt that the recent surge in commodity prices was a monetary phenomenon. He says that one indication of the potential for the policy to do more harm than good would come if the price of crude oil went above $90 per barrel (http://www.econbrowser.com/archives/2010/11/commodity_infla_2.html).
Perhaps, one of the explanations for the decline in commodity prices late last week is that policymakers are engaging in price-stabilization operations of the other kind. Whether or not such conspiracy theories laced with policymakers’ omnipotence have any credence, it is almost a certainty that they cannot succeed indefinitely with their price stabilization operations in any market. Put differently, the upside risk to commodity prices easily exceeds the risk of further decline.
Currently, only two major central banks in the world are pursuing asset purchase programmes. One is the US Federal Reserve and the other is the Bank of Japan. Sooner, rather than later, we might have the European Central Bank and the Bank of England joining them. In other words, if Prof. James Hamilton is right, then we are likely to see more money printed by more central banks and not less. Therefore, the outlook for commodities is “bright”. It means that the outlook for inflation is “bright” but not for discretionary disposable income in the hands of households in Asia.
What should Asian central banks be doing? IMF is quite clear in its report. Asian nominal policy rates, well below their average for the period 2002-07, are below the levels implied by an application of the Taylor rule (a rule that tries to determine the required level of policy interest rate based on the gap between potential and real gross domestic product (GDP) and inflation expectations). Real rates of interest too in Asia are negative or too low.
For Asian countries to combine capital controls with low interest rates serves no purpose. Capital controls are meant to prevent hot money inflows that allegedly follow higher interest rates in the domestic economy. In other words, capital controls should follow higher interest rates and not precede them.
So far, East Asian nations are doing the opposite. On the other hand, if they are sceptical about the regional economic growth forecasts and recovery globally in 2011, they should signal that to asset markets and investors in many ways. Clearly, asset prices in the region have decoupled from fundamentals. In fact, that means that central banks in the region must think of internal capital controls before they think of holding back hot money inflows from abroad.
Naturally, this might bring howls of protests of capital rationing, etc. Central banks and governments have been intervening in financial markets for dubious ends in the last several years. For a change, they could do so for a good cause. It is invariably the case that loose monetary policy and low interest rates encourage speculative investments rather than good investment that officials seek. That they are determined to inflict low interest rates on the economy with the fond hope of boosting the right investment spending in the economy in disregard of empirical evidence raises doubts about their intent or intellect or both.
Hence, for a change, they and their governments must consider either signalling or directing capital to inflation-unfriendly investments (those that lift potential GDP growth rate) than to inflation-friendly investments (stock markets and property). Signalling a dovish monetary policy in the light of the above is to invite the inflation dragon into the living rooms (pun intended).
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org