Although the stunningly swift rise in global markets from their depths last year seems to indicate that the world economy is getting back to normal, there are several major changes. One result of the crisis is that emerging economies have been much less damaged than the West. Growth is almost back to normal in the developing world, although part of it is due to very low interest rates and government support. In China, reports of labour shortages in the coastal districts have once again been making the rounds. HSBC Holdings Plc economist Robert Prior-Wandesforde says that in India, the percentage of firms reporting skilled labour shortages and the percentage of firms indicating they are operating “at or above an optimal level of capacity utilization” have already risen to comparatively high levels for the current early stage of the recovery. A survey by Hewitt Associates forecasts a 10.6% average rise in corporate salaries in India this year.
The rise in Chinese labour costs is significant. Recall that one of the reasons for the low inflation environment in the 1990s, the so-called “Great Moderation”, was the shifting of manufacturing to China and outsourcing to India. Another reason was the collapse of Russia and eastern Europe, which reduced demand while at the same time adding to the labour force. These forces kept a lid on commodity prices while at the same time lowering the prices of manufactured goods.
That environment has changed. The economies of Russia and Eastern Europe are no longer in the dumps. The Asian and other emerging markets continue to grow strongly. A World Bank paper by Raphael Kaplinsky and Masuma Farooki points out that infrastructure intensity is highest at the early stages of industrialization and at relatively low levels of per capita income, while new projects tend to be much more commodity-intensive compared with expansion and reconstruction investments. So growth in the developing economies will lead to higher commodity prices. The UBS Bloomberg Constant Maturity Commodity Index is currently around the same level as it was in December 2007, at the fag end of the last boom. And this is at a time when the current recovery is less than a year old!
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The $80 (Rs3,648) a barrel crude oil price that we’re seeing today was the price that was first breached in late 2007. The International Monetary Fund’s (IMF) commodity price index, which includes fuel and non-fuel prices, is forecast at around the same level for 2010 as it was for 2007. That’s a sea change from the price environment in 2005, when this index was almost the same level it was in 1995. Clearly, something has changed dramatically in the world since 2005, a structural change that the crisis only temporarily halted. It’s very interesting that commodity prices are back to 2007 levels in spite of the economies of the West still being badly hit by the crisis. What on earth would happen to prices once they recover? The Great Moderation, the period in the 1900s and early 2000s that saw low inflation, low interest rates and a very good period for global equities, is now finished. As economist Andy Xie has pointed out: “This process is over. China’s prices are the world’s (prices); its production costs are sure to rise due to a shortage of manual labour and soaring land prices. China can no longer hold back inflation during rapid monetary growth.”
In India, we’re seeing the effect of a change in the structural drivers of food inflation. A Citigroup Inc. report by Rohini Malkani and Anushka Shah says: “With rising per capita incomes, per capita consumption of food has also been on an uptick, thus putting pressure on food prices. The issue is further exacerbated by ‘nutrition transitions’, with an ADB study pointing out that emerging economies are seeing shifts in dietary patterns, towards higher quality and protein-rich foods like meat and dairy products.” Other structural factors include the Mahatma Gandhi National Rural Employment Guarantee Scheme and the rise in minimum support prices, which have increased demand for food.
True, the weakness of the Western economies will keep prices under control for some time. But as they start recovering, so will commodity prices. And if inflation rises, can interest rates be far behind?
India’s dependence on imported commodities, especially imports of crude oil, is well known. Rising crude oil prices have the potential to derail economic growth in the country at the same time as higher inflation leads to monetary tightening and higher interest rates.
Naturally, that will hit equities as well. A recent Citigroup report on India equity strategy by Aditya Narain and Tirthankar Patnaik says that “India’s correlations with ‘risk/crude’ have turned negative in the past with: a) Sharp increases in crude—repeatedly (three/four times), accompanied by underperformance vs emerging markets; b) ‘High’ levels of crude; crude above $90 has hurt the market most, in absolute and relative terms.” And further, “India is not a complete risk trade. While it does rise alongside other risk-assets in the initial part of every run, the dependence on global commodities soon works against it, as seen with crude oil.”
IMF’s latest forecast puts world economic growth at 4.3% for 2011. That could easily push crude oil above India’s comfort levels, dragging down growth and the markets.
Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org