Asia?s emerging markets are suffering from a strange policy dilemma. While growth in most of these countries is showing signs of a deceleration, along with a marked decline in economic activity, the expected corresponding decline in prices is not occurring. As a result, the markets are finding it hard to adopt countercyclical policies.
India is one of the best examples. The latest quarterly GDP is estimated at 7.7%. Some slowdown, which may only be seasonal though, is seen in parts of industrial production and manufacturing. Conventional economic logic would predict the economy having entered a cyclical phase of partial downturn, likely to be corrected over the next few quarters. Conventional logic would also expect prices to soften along with the temporary setback in growth. However, inflation shows little signs of abating with commodity inflation persisting at high levels. Similarly, in China, food inflation remains high, and overall inflation is close to 7% despite the economy showing signs of partial cooling. Inflation is above 5% in South Korea. Price pressures are high in Indonesia and Singapore, as well, despite the latest growth figures showing moderation.
The growth prospects for all these economies are weak on two accounts. First, their export demands have shrunk due to contraction in European and American markets. Going by the latest forecasts of the OECD for its member countries, growth outlooks of industrialised nations are unlikely to improve immediately, particularly in Europe. Even Germany, the best performer in a continent fighting hard to remain financially solvent, will face a much slower rate of GDP growth in the coming months. The rest of Europe appears to be suffering from an irreversible lack of confidence and stunted economic activity. They are unlikely to be as accommodative of Asian exports as they were even a year earlier.
The second factor constraining Asian economies is their own domestic market weaknesses. Infrastructure does not appear to be producing the magic it earlier used to and is unable to shore up effective demand. Capital markets have become weak due to desertion by FIIs. The resultant lack of earnings has affected real estate demand in several markets. With capital and property markets slowing, services sector growth in most economies has started dipping. At the same time, manufacturing is not experiencing new additions to capacity as high interest rates are constraining investment.
The dilemma for monetary policy authorities in Asian economies is: what to do with interest rates? High headline inflation has forced them to adopt a restrictive policy until now. Key policy rates all over Asia have progressively hardened for combating inflation. Sooner or later, high interest rates had to affect investments, and they have begun doing so. Asian central banks would have loved to take this opportunity for reversing policies and adjusting interest rates downward in countercyclical response. But they are being prevented from doing so by headline inflation rates that still remain high.
Much as one can sympathise with the plight of central banks in the region, there are concerns over their indecisiveness becoming rather costly for their economies. Interest rates have lagged effects on investment. The sustained rate increases have finally begun acting by discouraging investment. By the same token, downward revisions in rates would not see investments recovering immediately. Investors would wait and watch until they are convinced about the stance of the policy. What this means is that a correction of rates would kick-off investments only after some time. And the later such corrections are, the longer would investments take to recover.
While, for Asian central banks, the next few months are likely to be anxious periods, the limited or almost negligible impact of progressively high interest rates on inflation should convey unambiguous signals to the authorities. Inflation in the region is unlikely to be tamed by interest rates. Food inflation, in particular, has clearly exhibited its insularity from interest rate hikes. For commodities as a whole, the sources of inflation are probably not those that can be influenced by interest rates at all. In other words, they are non-monetary in nature. Factors driving food prices across Asia might vary from country-specific supply and distribution factors to certain common reasons such as spikes in oil prices. But whatever they be, they are surely not to be affected by interest rates.
Asia?s experiences with interest rates and inflation in recent years are likely to lead to extensive analysis of whether classic monetary policy responses are useful for tackling prices in all situations. Sticky prices in Asia have blunted the responses. While economic theory and literature will benefit from the academic introspection, Asian economies are bracing for a period of policy uncertainty.
The author is a visiting senior research fellow at the Institute of South Asian Studies in the National University of Singapore. These are his personal views