China Leads Asia in Retreat From Inflation Battle

China Leads Asia in Retreat From Inflation Battle (Update2)

By Shamim Adam and Kevin Hamlin

June 2 (Bloomberg) -- Plummeting currencies did in the first Asian economic miracle. The second may fall victim to surging inflation.

Central banks from Beijing to Bangkok are losing their bets that a global slowdown would temper price increases. While export demand from the U.S. and Europe may have eased, it has been replaced by rising domestic consumption that has helped push inflation rates in Asia as high as 26 percent.

The result: In China, Thailand, the Philippines and at least eight other Asian economies, benchmark borrowing costs are lower than the rate of inflation, resulting in negative real interest rates, according to data compiled by Bloomberg. The risk is that prices will spiral even faster, leading to overheated economies and an eventual bust.

``Unless there are concrete measures to tackle inflation, investors are going to reconsider the Asian growth story and realize it's not as rosy as it seems,'' says Sailesh Jha, an economist with Barclays Plc in Singapore. ``Confidence will weaken, and there'll be a significant correction in asset prices such as stocks as capital flows out.''

Thailand's central bank has held its main rate at 3.25 percent for almost a year, while inflation has tripled to 6.2 percent. The People's Bank of China, which announced in early December a planned shift to a ``tight'' monetary policy, has kept its main lending rate unchanged at 7.47 percent since the end of 2007, even as inflation soared to 8.5 percent, near a 12- year high.

Earthquake Aftermath

China's policy makers risk losing more ground in the aftermath of last month's devastating earthquake, which has increased pressure on banks to lend more for rebuilding.

The central bank in a report today reaffirmed its intent ``to implement tight monetary policies,'' saying that exports won't cool ``drastically'' and that it regards rising prices as the bigger threat to the world's fastest-growing major economy.

Without stronger anti-inflation action by the central bank, ``the eventual correction will come at a much higher price,'' says Kevin Lai, senior economist with Daiwa Research Institute in Hong Kong. ``The more the problems get delayed, the greater the risk. The subsequent bust cycle will be long and painful.''

Asia's boom of the 1980s and early 1990s ended with Thailand's devaluation of the baht in 1997. That set off a chain reaction of plunging currencies and a stampede by foreign investors rushing to pull money out of the region.

Governments Divided

Now governments in Asia, where about 600 million people survive on less than $1 a day, have been divided between the need to rein in surging prices and to shore up growth. Countries including Malaysia and the Philippines have avoided raising interest rates, relying on price controls and subsidies to keep inflation contained.

``Policy makers were expecting slower global growth to bring down inflation and do their work for them,'' says Robert Prior Wandesforde, a senior economist at HSBC Holdings Plc in Singapore. ``That's not going to happen. Monetary policy is incredibly loose, and they have a lot of catching up to do.''

Bank lending climbed 14.7 percent in Vietnam during the first four months of 2008 after a 50 percent increase last year, and rose 24.4 percent in Singapore in April compared with a year earlier. China's factory and property spending gained 25.7 percent in the four months through April.

Even before the earthquake struck China's Sichuan province May 12, Chinese policy makers were hesitating to increase interest rates for fear of undermining efforts to curb speculative capital inflows.

Reconstruction Costs

Reconstruction after the disaster could eventually cost China 1 trillion yuan ($144 billion), adding demand and pricing pressures to an economy already in danger of overheating, according to an estimate by Andy Xie, a Shanghai-based independent economist.

China's banks had committed 82.7 billion yuan for reconstruction loans as of May 21, the China Banking Regulatory Commission said. As the government ``pressures'' banks to process these loans quickly, inflation may accelerate to 10 percent as early as this month, says Glenn Maguire, chief Asia- Pacific economist at Societe Generale in Hong Kong.

Taylor's Warning

Asia's economies aren't the only ones falling behind. ``Globally, short-term interest-rate changes set by central banks have not increased on average by as much as inflation,'' John Taylor, a Stanford University economist and author of a monetary-policy formula often cited as a benchmark, said in a Tokyo speech May 28. ``This is counter to key monetary principles.''

Brazil's policy makers raised their benchmark rate in April for the first time in three years as inflation exceeded 5 percent. The same month, consumer prices in Venezuela's capital, Caracas, were 29.3 percent higher than a year ago, indicating the central bank's higher borrowing costs have done little to quell Latin America's highest inflation rate.

In Russia, the central bank's two rate increases this year have failed to damp consumer prices, which were up 14.3 percent in April from a year earlier, the fastest acceleration in five years.

The spiraling prices threaten the credit ratings of emerging-market nations, Fitch Ratings said in a report May 27. Russia is the most vulnerable of the so-called BRIC economies, which also include Brazil, China and India; in Asia, Vietnam and Sri Lanka are among the top 10 at risk, according to the report.

Coming From Behind

Some central banks in the region are attempting to make up for lost time. Bank Indonesia, which cut its benchmark rate 14 times between May 2006 and December 2007, raised borrowing costs by a quarter point May 6 and said it will consider further increases. Inflation in Southeast Asia's largest economy may accelerate to as much as 12.5 percent by year-end, central bank Governor Boediono told lawmakers today.

Pakistan's central bank on May 22 unexpectedly decided to increase the benchmark rate for the second time this year to slow the fastest inflation in at least 25 years.

Vietnam's central bank still finds inflation gaining on it, even after boosting borrowing costs half a percentage point to 8.75 percent in February. It kept rates unchanged in March and April, declaring that the February move and other measures were sufficient to keep consumer prices contained.

`Not Suitable'

They weren't. In May, central bank Governor Nguyen Van Giau said rates ``were not suitable with the market situation'' and raised them by 3.25 percentage points. Inflation reached 25.2 percent that month.

Some central banks haven't yet joined the battle. Sri Lanka has left its repurchase rate at 10.5 percent for 15 months. With a May consumer-price gain of 26.2 percent, that gives the country the lowest real interest rate in the region.

The Bank of Thailand last lowered its policy rate in July, while Malaysia's central bank has kept borrowing costs unchanged at 3.5 percent since April 2006. In the Philippines, the central bank hasn't raised rates since October 2005.

Policy makers in those three countries have said they are prepared to raise rates as inflation quickens. Jha of Barclays doubts they will keep their promise.

``The reality is that they'll wait till the last minute,'' Jha says. ``They'll do too little too late.''