Week Ended: June 27, 2008

More Light Than Heat

Worries over inflation and commodity prices are now pervasive throughout global financial markets. From China to India to the U.S., investors everywhere appear concerned about the high and rising prices associated with their daily consumables. Some pundits also predict persistent shortages of key resources that could swamp economic prospects for many years to come.

We share some of the current concern over inflation. During the last few years, we have highlighted ways growing inflationary pressures might pose challenges to Asia's future growth (please see a retrospective of our commentaries on inflation below). In brief: high levels of inflation pose a twin threat to the region. First, rampant inflation may provoke economic disorder or even collapse, as has been witnessed throughout history in hyper-inflation states. This terrible threat can never be wholly exhausted in emerging Asia. But save for some smaller markets such as Vietnam, the risk of major disorder does not seem particularly acute at present. The second threat arises from government: in a desperate bid to dull the impact of inflation on constituents' living standards, governments may enact unsustainable policies that either stoke inflation or make it more permanent. It is this risk that is most prevalent in Asia today.

So, present concerns are at least partly justified. Yet if one takes a longer-term view of inflation in Asia, one can see that its origins are highly complex, and its workings are not entirely negative. In our view, most of Asia's inflation has its roots in the regions' currency policies—policies that are deeply intertwined with the region's economic evolution. Over the past few decades, Asia's economies have grown in size, sophistication and depth. Under free market conditions, this sort of growth would normally cause Asian currencies to adjust in a manner that reflected the region’s enhanced productivity. Yet for a variety of historic, economic and political reasons, governments in Asia have been reluctant to allow their currencies to adjust freely. This policy may have engendered the current bout of inflation: As currency prices have been constrained, domestic prices appear to have been forced to absorb the brunt of the adjustment, via inflation.

There is a silver lining to this cloud: Whereas Asian governments might have the capacity to control or otherwise constrain their currencies, they have far less ability to administer the micro-adjustment of millions of prices for goods and services across their domestic economies. The market may be messy, but it is at work: Prices are seeking a new and more sustainable level, irrespective of government efforts to tamp them down. The transition will be a rocky one. Financial volatility has been and will be a byproduct. Yet as long as no self-destructive policies derail the process, the end result should promote more sustainable growth. Over the longest term, this would represent an unmitigated positive outcome, in my view.

Regards,

Andrew T. Foster
Acting Chief Investment Officer and Portfolio Manager
Matthews International Capital Management, LLC

Previous Commentaries on Inflation

	Asia Pacific Running Hot and Cold (3/2008) Inflation arising from Asian markets might overwhelm even deflationary pressures arising from a U.S. credit cycle contraction. Diverging Paths (9/2007) Burgeoning inflation in Asia mean that central banks there may not have the scope to cut rates, even as the U.S. Fed is under pressure to push rates lower. A Juncture in the Path (4/2007) Lead by China and India, Asian nations may allow greater currency flexibility in order to avert the worst affects of domestic inflation. What's In Your Basket? (9/2006) A brief study of the region’s consumer price index baskets, most of which are, for historical reasons, dominated by food-related items. Interesting Times, Part 2 (8/2006) In 2004, a moderate dose of inflation might have been welcome in Asia. By 2006, stronger inflation pressures were emerging—and any “slack” in the region’s interest rate cycle had been exhausted. Interesting Times (9/2004) Back in 2004, we argued that Asia’s rigid currency policies might give rise to somewhat higher inflation—and provided that inflation remained moderate, it might actually do the region some good.
	China China's Inflation Weekly (11/2007) China's government walks a fine line between policy response to inflationary pressures and political fallout. A Tough Job - And Perhaps No One Needs to Do It (8/2007) In China, fewer prices are administered by the government than they once were; still, many prices suffer from a surprising degree of intervention, confounding even expert China watchers.
	Japan What You Wished For (6/2008) Inflation may at long last be returning to Japan—and for this market, depressed by years of deflation, it may be a welcome change. Postcard from Japan (4/2008) Signs of inflation on the ground in Japan might bring about important change. Japan Update (10/2007) Some consumer goods in Japan see their prices hiked for the first time in 17 years.
	India India 2008 Q1 Commentary Looking forward, inflationary pressures remain one of the greatest difficulties for the Indian economy—not least because they are beginning to erode some companies’ profit margins. India 2006 December Commentary (pg. 46) Financial market volatility and inflationary pressures are two threats to India’s growth story. Inflation in India (8/2005) Energy subsidies and potential inflationary consequences remain one of India’s greatest bugbears.

 

 

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The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information.