Inflation from Asia: The next crisis

By Jim Jubak

Inflation is out of control. Even by wildly understated official measures, prices are climbing at two -- or more -- times government targets. And with central banks printing money and flooding the financial markets with cash, inflation is going to get a whole lot worse before it gets better.

In the United States? No. At least not yet.

Look to Asia if you want to see runaway inflation now. In China and India, inflation looks like it's headed for double digits. Even inflation stalwarts such as Singapore are feeling the pressure.

And in Vietnam, the inflation genie is clearly out of the bottle, with prices climbing at an annual rate of 25% in April. (Japan, as it has been for much of the past two decades, is the regional exception.)

Even with the financial crisis that started in the subprime-mortgage market still far from over, I'd rate runaway inflation in Asia as the greatest danger to the global economy.

For a problem so big and so important, inflation in Asia is still off the radar screen for most U.S. investors. (U.S. consumers have their own problems at the gas pump and grocery checkout counter to absorb their attention.) Here's a quick rundown of inflation across the continent:

As bad as these numbers appear, they're actually worse than they look. Many, even the low readings from Malaysia and Taiwan, represent longtime highs that are accelerating rapidly.

In Malaysia, for example, the 3% annual rate for April was a 15-month high, and the central bank is now predicting inflation will climb to 4.2% for all of 2008. That would be the highest inflation rate in Malaysia since 1998, when, during the Asian financial crisis, inflation averaged 5.3%. In Taiwan, Citibank Taiwan recently raised its projection for 2008 inflation to 3.29% on average for the year. That would be the fastest inflation jump since 1995 and is up from the company's February projection of just 1.98% for 2008.

Rate increases push down stock market

Why is Asian inflation such a huge danger, first to national economies and then to the global economy?

Look at what has happened in Vietnam in just the past few days as that country's central bank has decided to fight inflation. The State Bank of Vietnam raised interest rates to 14% from 12% on June 11. That's the third increase in interest rates this year.

Those interest rate increases have crushed the nascent Vietnamese stock market. The VN, an index of 151 companies on the Ho Chi Minh Stock Exchange, was down more than 60% for 2008 as of June 11. And the government is predicting economic growth will slow to 7% for 2009 from last year's 8.5%.

That seems wildly optimistic because even an increase in interest rates to 14% isn't nearly enough to fix the problem. With inflation running at 25%, interest rates of 14% are still hugely negative. That is, borrowers are paying just 14% interest at the same time as inflation is reducing the real value of the currency they have to repay by 25%.

Borrow and spend everything

Negative interest rates are a huge impetus to future inflation. Negative interest rates give no incentive to save. In fact, the rational response is to spend everything you have today, since any money will be worth less tomorrow. And then borrow as much as you can, since inflation is giving you a free ride.

At some point, it all comes tumbling down. An overheated local economy has driven Vietnam to a huge trade deficit, one that Morgan Stanley (MS, news, msgs) says could grow to an unsustainable level in 2008. Deutsche Bank (DB, news, msgs) predicts that Vietnam will have to devalue its currency, the dong, and that the country might need to impose the Draconian combination of budget cuts and high interest rates that the International Monetary Fund has proposed in similar crisis situations.

The dong could go into free fall in 2008. The central bank raised the official daily reference rate against the dollar to 16,461 on June 11. (The currency trades in a 1% band on either side of that rate.) But before the bank moved, the dong already traded at 18,500 to the dollar on the unofficial market run by Vietnam's gold shops. Overseas futures traders are pricing 12-month futures for the currency at 22,575 to the dollar. That's a bet that the dong will fall a further 37% from the current official rate in the next year.

U.S. response provides an example

The standard medicine for runaway inflation is to raise interest rates above the inflation rate. That's what the U.S. Federal Reserve did to end the inflation of the late 1970s and early 1980s. Annual inflation peaked at 13.3% in 1979. The U.S. prime interest rate, the rate charged to a bank's best customers, hit 20% in April 1980, dropped slightly and then peaked at 21.5% in December 1980. Inflation dropped to 12.4% in 1980, 8.9% in 1981 and 3.9% in 1982.

Continued: 1980 recession

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