Inflation from Asia: The next crisis

Ratcheting up interest rates to that level brought the U.S. economy to a standstill. Annual real GDP growth (that is growth in gross domestic product after subtracting inflation), which had been a huge 5.6% in 1978 and a still solid 3.2% in 1979, turned negative in 1980. That year's overall 0.2% decline in growth masks the full force of the 1980 recession. U.S. GDP fell a whopping 7.8% in the second quarter and declined 0.7% in the third.

Vietnam's people are looking at some tough times ahead if the country has to administer that kind of inflation medicine.

Bad news across the continent

And if high and increasing inflation rates plus negative interest rates are indicators of runaway inflation -- and I think they are -- the rest of Asia isn't in much better shape. Interest rates are negative all across the continent. According to UBS (UBS, news, msgs), interest rates in Asia, excluding Japan, are negative by an average of 1.7%.

That average hides huge variation. India and Taiwan, for example, are in relatively good shape. Getting their interest rates from negative to positive territory in order to combat inflation will require only modest increases in interest rates. In India, where inflation recently hit 8.24%, the Reserve Bank of India's benchmark interest rate is 7.75%, so rates are negative by a "modest" 0.49 percentage point. In Taiwan, where inflation recently hit 4.1%, the benchmark rate is 3.5%.

Countries such as the Philippines and Indonesia have much further to go. The governor of the Philippines' central bank projects inflation will peak at 11% in 2008; the bank's benchmark interest rate overnight now stands at 5.25% after a 0.25-percentage-point increase in June. In Indonesia, the benchmark interest rate stands at 8.5%, lagging inflation, which was running at 10.36% in May.

China's inflation future unclear

Where China stands depends on what you think the long-term inflation trend in that country really is. In May, inflation dropped to an annual 7.7% from April's annualized rate of 8.5% as the pace of increases in food prices slowed. If that drop is an indication that the central bank has tamed inflation, that's good news. The People's Bank of China has raised reserve requirements -- the percentage of a bank's cash that the bank has to hold in reserve rather than lending -- five times in 2008, to 17.5% effective June 25. Maybe that's done the job.

On the other hand, the drop in May inflation may be just a temporary event caused by a pause in food price inflation that won't last. Data that show bank loans climbing by 15% from a year earlier certainly suggest that the latest steps from the People's Bank haven't cooled the economy enough to make a long-term drop in inflation likely.

Cheap yuan helps jobs, hurts inflation

If that's the case and inflation isn't whipped, the People's Bank faces a big decision. Chinese interest rates right now are deeply negative. The official benchmark rate for deposits is just 4.14%. The bank raised interest rates six times in 2007. If those interest-rate increases and the increases this year in bank reserve requirements haven't worked, then what?

Then the bank will have to confront the ultimate source of the country's inflation: its undervalued currency. China's government likes a cheap yuan because it keeps the country's exports growing and its factories humming. That, in turn, means more jobs.

But keeping the yuan cheap when China's trade surplus ran at $58.5 billion for the first four months of 2008 is expensive. All those dollars and other currencies flooding into the country increase the money supply and add to inflationary pressures. To reduce those pressures, the People's Bank of China issues bonds to buy dollars in an effort to soak up the extra money.

This kind of intervention never succeeds in soaking up all the cash inflows, however, and in China's case, the task is made more difficult by cash inflows from investors who want to put their money to work in the country. Such investment cash came to $160 billion in the first four months of 2008.

Effects of a slowing China

The yuan is up 5.2% against the dollar in 2008. That and a U.S. economic slowdown have been enough to slow China's export growth. The export surplus could actually fall in 2008 from the 2007 record. A smaller export surplus and higher reserve requirements are projected to slow the growth of China's economy to 10% to 10.5%, down from 11.9% in 2007.

But if the yuan is allowed to rise further, if the People's Bank raises reserve requirements again and if the central bank decides to raise interest rates again in order to fight inflation, then China's growth could slow even more in 2008. Not to zero, certainly, but maybe to 8% or 7%.

Continued: Impact on global economy

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