Asian sovereigns: The
politics of inflation
Summary
Two months ago we warned that the Asian
credit market could become unhinged by
rising inflation (see The View, May 2008).
The inflation trend in Asia is today well
established, the only uncertainty is the policy
response to be adopted by Asian countries.
Although the initial up-tick in inflation can be
blamed on higher energy and food prices, we
think the run-up in prices will prove to be
persistent and require a vigorous monetary
policy response. Inevitably, it comes down to
a choice between growth and price stability.
This choice is, at the end, shaped by the
politics of the day.
From a sovereign credit perspective, it is
important to guard against run-away inflation
as it can unravel a country’s credit metrics in
more ways than one, particularly in emerging
markets. In Asia, there is a strong interplay
between inflation and government finances as
subsidies play a major role. In addition, runaway
inflation can weigh on a country’s
balance of payments.
It is our contention that countries that respond
more aggressively to inflationary pressures
will emerge from this period with their credit
profiles relatively unscathed. High inflation
on its own is not a precursor to credit profile
deterioration – however high inflation
combined with balance of payments weakness
and government budgetary strain are
contributory ingredients for turmoil. In such
an environment, fighting inflation should take
the utmost priority, in our view. Hence, we
assess below the political dynamics that
shapes the willingness and ability of Asian
countries to respond to inflation.
As a general strategy, we recommend being
underweight sovereigns as we expect
authorities in Asia to be behind the curve in
fighting inflation. This recommendation is
unchanged from our position at the start of the
year, although at that point it was on
consideration of valuations being rich. Now
we expect some fundamental deterioration
with risk of new supply.
Within the sovereign space, countries that are
particularly vulnerable are Indonesia and
Malaysia, as domestic political conditions
impose a considerable constraint that prevents
policymakers from ‘doing the right thing’ –
we think current risk premiums understate
this risk. We are most comfortable with Korea
despite recent protests against President Lee,
as the economy has considerable flexibility
and it appears that the interests of the
government and the central bank are
reasonably aligned to keep inflation in check.
Reflecting our views, we recommend (1)
going long 5-year Malaysia CDS at 128bp
(ask) and short 5-year Korea CDS at 112bp
(bid) for the spread differential to push out to
50bp; (2) Long 5-year ROI CDS at 305bp
(ask) and short 5-year ROP CDS at 280bp
(bid) for the spread differential to widen to
the 60bp; (3) Long 5-year China CDS at 79
(ask) for a move out to 100bps area by end-
4Q – using China as a proxy for regional
sovereign weakness.
Monetary policy neglect hypothesis
Before we turn to assess the political enthusiasm
of each individual Asian country under our
purview to anchor inflation expectations before it
results in a shift up in actual inflation, we briefly
look back at the US inflation problem of the
1970s. In our opinion, this period most closely
resembles the possible threat facing the Asian
region today with regards to monetary policy
neglect.
For most of the 1970s, most of the literature
agrees that US monetary policy was, in retrospect,
too accommodative and greater restraint would
have likely led to lower inflation and hence, less
economic loss to achieve the former. Most
interesting was that both policymakers and the
Fed attempted to validate why monetary policy
should not respond in a forceful way to rising
inflation following the first oil shock in 1973.
Some of arguments were ‘a permanent long-run
trade-off between the level of unemployment and
the level of inflation’; the output gap mismeasurement
and cost-push inflation. Simply put,
there was a tendency to explain why the various
shocks pushing inflation up as temporary,
resulting in monetary policy being
accommodative with real interest rates hovering
in negative territory from 1973 to 1979 (see
Fig.1). It is worth highlighting that the US dollar
was also under tremendous downward pressure
against the Deutschmark and, to a lesser extent,
the Japanese yen during this period of so-called
‘monetary policy neglect’ (see Fig.2 ).
From late 1979 onwards, however, new Federal
Reserve Chairman Paul Volcker chose to focus on
aggressively restoring price stability regardless of
the origins behind the upward pressure on
consumer inflation and demand for wage
compensation by employees. To be more specific,
the Fed focused on money supply growth and
maintaining a relatively high short-term real
interest rate environment to push inflation
expectations downward (see Fig.1). For its part,
the government’s move to unleash competitive
forces on domestic industries and weakening the
labour unions also undermined the relationship
between prices and wages. With the restoration of
monetary credibility, both the US equity market
and US dollar reacted positively with the latter
recovering strongly against the Deutschmark and
Japanese yen that the G-7 finally agreed in 1985
(Plaza Accord) to intervene in the FX market to
reverse the troubling global trade imbalance (see
Fig.2).
With a basic understanding of what transpired in
the US from the early 1970s to early 1980s, we
are concerned by the similarities of that difficult
period with what the Asian region might face in
the months ahead. Today, Asian policymakers and
central bankers, like their US counterparts three
decades ago, are trying to provide rational
explanations as to why the inflation shock poses
no serious threat to long-term economic growth
prospects. As a result, we still see both fiscal and
monetary policies being aligned with sustaining
growth rather than containment of price pressures
and wage demands. This belief is best illustrated
by the negative real policy rates across the Asian
region, despite the monetary tightening seen over
the past twelve months (see Fig.3).
Inflation psychology
To be more specific, we believe the financial
markets are right to fear that inflation expectations
are not well anchored at the pre-oil, basic metals
and agricultural price shock level. Still relatively
easy monetary policies and fiscal subsidies are
diminishing the full impact of softening US
demand and the trade shock attributed to higher
than expected prices for energy, basic metal and
agricultural products on most Asian economies. If
anything, Asian economies are growing above
trend output and hence, intensifying pressure on
scarce natural resources due to policymakers’
reluctance to reverse accommodative government
polices. More troubling, however, must be the
mostly closed nature of the Asian economies’
various domestic sectors and the wage setting
processes in both the private and public sectors
being influenced by trade unions and populist
policies. In other words, we think there is a strong
chance that the perceived temporary trade shock
(fuel and other commodities) will turn into higher
wages, resulting into an enduring inflationary
shock, i.e. higher steady-state inflation going
forward.
On the other hand, we would do not believe that
the US faces the same inflation threat. We have
argued before on a number of occasions that the
combination of asset deflation in the leveraged US
economy where unemployment has started to tick
up has a greater risk of a sharp drop-off in growth
going forward. Generally, this type of outcome
points to margin compression for businesses
rather than an upwards shift in core inflation
expectations as households refrain from
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