Posted by:
Andrew Bell

22 February 2011

A recent visit to the Far East left me with three principal impressions. The first was the optimism about economic prospects from managers looking at the continental Asian economies – there is a palpable belief in things getting better, in contrast with the prevailing media morosity in the West. The second was scepticism over the pace of economic reform in Japan. The words “gradual” and “glacial” kept coming up, which is a tribute to national stoicism after 20 years of near stagnation in nominal GDP. The final impression, which is gaining most comment in the developed market press, is the upturn in inflation in rapidly growing economies, driven by commodity prices.

Turning first to Japan, it is striking how low expectations are regarding the pace of reform. After 20 years characterised by weak economic growth and deflation in asset prices, the political and monetary authorities have yet to forge a consensus on how to generate a recovery in consumer spending and reverse the trend of falling prices. Companies have gradually slimmed down their high cost domestic businesses and expanded in China but have been slower than those elsewhere to release value for shareholders. Growth in profits (despite the weak domestic economy) has been more than offset by lower PEs. Although Japanese companies increasingly feature in cross-border screens of “cheap” shares, it is hard for market mechanisms to catalyse the release of this value. The period of disruptive change in economic prospects when Japan went from boom to deflationary bust in the 1990s created many casualties but companies now appear hardened against further privations, allowing a degree of decoupling from the stuttering domestic economy. This also allows them to resist pressure to restructure.

An additional risk is the multiplication of the Government’s debt as a proportion of GDP (to over 200%). So far, this has been offset by an 80% fall in government bond yields (to 1.3%) and a shortening in debt duration, leaving the interest servicing cost on the debt little changed. However, it is easier to see interest rates rising than the debt falling, so at some stage doubts will rise over the sustainability of the fiscal arithmetic.

This day has been deferred owing to the domestic savings surplus, which has enabled the government to fund itself without recourse to foreign capital flows. The trees and bushes in Tokyo’s public parks are all precisely trimmed into “Dr Seuss” type shapes - landscape gardening with scissors. The economy gives a parallel impression of being under control but with its growth suppressed – a sort of bonsai exhibit full of biltong companies that seem unlikely to perish but from which it is hard to derive full satisfaction.

The rest of the region has more obvious growth momentum but the rapid pace of growth has combined with a series of supply shocks for commodities to create resurgent inflationary pressures, forcing regional central banks to tighten policy to bring inflation down.

Aside from the routine cyclical nature of this policy shift, there is more than usual political sensitivity to current inflation trends, owing to the higher proportion of food costs in the cost of living baskets of emerging economies –a third in China vs. one tenth in the UK. From ancient Rome to the present day, hungry urban populations are politically unpredictable. A rise in basic food costs produces immediate pressures for higher wages, since there are few areas of discretionary spending to be squeezed to maintain spending on necessities. In contrast with western economies, where commodity price rises act as a tax rise, depressing other spending areas, commodities have a directly inflationary (and politically incendiary) effect on economies where much of the population is closer to   subsistence levels.

As a result, many Asian economies are raising interest rates and introducing restrictions on bank lending and property speculation, to prevent the current economic boom from morphing into an inflationary accident.

This poses a number of risks to the investment climate. One is that the authorities may fail in their efforts to produce a controlled slowdown (or soft landing). If a recession is caused by efforts to contain inflation, this would have serious political side-effects (given, for instance, the pressure to create jobs in China) as well as undermining the prospects for global economic growth, since a disproportionate amount of the world’s growth in the past five years (55%) has been sourced in Asian economies accounting for only 28% of the world’s economy. The prospect of that growth weakening substantially while western economies are still trying to emerge from the aftermath of the credit crunch would be unsettling, risking stagflation in the west coinciding with a cyclical hard landing in the east.

Some regional managers felt that there had been local speculative stocking of commodities, as well as a rise in manufacturers’ inventories. If a cyclical slowdown occurred, there could therefore be an abrupt correction in commodity prices. Inflationary pressures would then appear much less threatening. It seemed likely to be some months before this would become clear so there was a degree of tactical caution. The general expectation is that the authorities will act tough in coming weeks to try to engineer a controlled slowdown by midyear, with further interest rate rises and (possibly) currency appreciation. This would usher in a more positive market backdrop in the autumn, when the interest rate cycle should cease being a headwind in the East, potentially just as it begins to become one in the West.

Although the commodity surge is presenting Asian central banks with a genuine policy problem, as rapidly growing economies with high commodity dependency face traditional overheating pressures, it risks creating a policy error in western economies, if central banks overreact to a rise in food and energy prices that is more likely to act as a (deflationary) tax increase than a driver of inflation. With most of the developed world (other than Belgium) having abandoned wage-price indexation, changes in relative prices affect living standards but the prevailing inflationary climate will be influenced by the wider state of the economy. The UK is already facing a fiscal squeeze and the deadweight of the debt overhang. Anything more than a symbolic nudge on rates risks being a futile overreaction – it will make no difference to the main drivers of global inflation - food harvests and uncertainty over oil production.

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