Asia Insight

August 2006

Interesting Times, Part 2

Andrew T. Foster, Director of Research, Portfolio Manager
Matthews International Capital Management, LLC

In the September 2004 issue of Asia Insight, entitled "Interesting Times," we suggested that a moderate dose of inflation could do Asia some good. Our idea rested on two points: first, Asian economies were generally growing faster than their developed-country counterparts, and all else being equal, this would tend to beget higher prices for Asian goods and services. Second, in 2004, Asian governments exhibited a strong preference for steady exchange rates versus the dollar; with Asian currencies thus held stable, the upward pressure on Asian prices had one outlet: domestic inflation.

In most instances, inflation is the nemesis of the long-term investor. However, in 2004, a moderately higher level of inflation in Asia was not unwelcome – provided that it did not escalate out of control. Given Asia's higher growth rates and quasi-fixed currencies, rising prices did not necessarily constitute erosion in the value of money, but instead indicated improved purchasing power and the creation of wealth.

Incomes in most Asian economies (excluding Japan) are lower than those of developed economies. In order to achieve incomes on par with richer nations, Asian countries must generate productivity gains, manifested in higher quantity and better quality output per person. As individuals produce more and at better quality, they should be able to demand higher wages, thereby improving incomes and living standards. Meanwhile, rising labor costs and higher product quality should prompt companies to boost prices to protect (or expand) profit margins. Under a freely-floating exchange rate system, the resulting pricing pressure might be absorbed through currency appreciation: trading partners would simply pay Asia more for its goods and services. However, the historical stability of Asian currencies has meant that domestic prices must bear the brunt of any upward adjustment — resulting in a more “beneficial” form of inflation.

Inflation of this sort was visible in Japan following World War II. In 1949, the Japanese yen was fixed at an exchange rate of ¥360 per $1.00. That rate held until 1971, and thus only domestic prices could adjust to the country's productivity gains — much like the rest of the Asian region today. Between 1955 and 1971, when Japan's post-war growth was accelerating, annual inflation averaged about 4.4%, versus about 2.6% in the United States.¹ This sort of high differential inflation often undermines currencies; one might have reasonably expected the yen to decline versus the dollar when it began trading in 1971. The opposite occurred. The yen appreciated almost immediately, and by 1974 it broached ¥270 per dollar, 33% higher.²

The yen's strength after 1971 defies simple, single-factor explanation. Nonetheless, its immediate and sustained rise suggests that Japan's higher inflation was not particularly detrimental to the country's long-term economic health. In essence, Japan's pre-1971 productivity gains were expressed in part through rising domestic prices. Post-1971, the yen absorbed a much larger portion of the country's productivity gains, in lieu of domestic prices. This trend held up to the present: the currency has since strengthened to the ¥120 range, even as average Japanese inflation subsided to 3.2% (versus 4.7% in the U.S.).³

Though investors must always be wary of all inflation, they may benefit from this more benign form, particularly if they train their portfolios towards companies that benefit from rising consumption and higher levels of domestic wealth. In doing so, investors participate in the very income gains that are driving prices higher in the first place. Inflation remains dangerous though, because once initiated, it is difficult to control. This is particularly true in the Asia context, where financial systems are weak, and the independence of central banks is often compromised.

In 2004, higher levels of Asian inflation were not only welcome, they were needed. Japan was mired in a deflationary environment, and China had only just escaped outright deflation. Both countries had seen deflation cripple growth, particularly as consumers held back purchases in anticipation of lower prices in the future. As domestic consumption faltered, both nations also become even more dependent on external, trade-led growth in order to stimulate their economies.

Our argument then was that higher levels of inflation were not necessarily worrisome, particularly in China and the rest of Asia ex-Japan, which were undergoing strong economic expansion. At the time, Asia enjoyed a fair amount of "slack" in its interest rate cycle: the region stood to benefit from higher prices, even as the rest of the world began to raise interest rates to stem inflationary pressures. As the table at the beginning of this article demonstrates, the U.S. Federal Reserve hiked rates by 4.25% over the last two years. Asian central banks also increased rates, but most did so to a much lesser extent. Asia effectively enjoyed extended holiday from rate increases.

Now, in 2006, Asia's rate "slack" is largely exhausted. At the time of this writing, the U.S. paused in its recent string of rate hikes. Prominent economists differ widely on whether further increases are warranted. However, should the future hold another round of global interest rate increases, central banks in Asia ex-Japan will find it much more difficult to stand pat. Economic growth in the region has accelerated, input costs have risen, and credit growth has picked up - all of which suggest that Asia has less scope to be complacent about inflationary pressures. Anecdotal evidence of inflation is growing: Chinese vendors are apparently beginning to push for price increases with U.S. retailers; Indian companies are struggling with wage increases between 10% and 15% across most industries. With less sophisticated monetary instruments at their disposal, Asian central banks may be forced to act earlier, and in cruder fashion, to head off inflation. Indeed, even as this publication went to press, China increased interest rates for the second time this year.

To be sure, higher rates in Asia are not a foregone conclusion. Perhaps the most substantial caveat lies with the region's currencies: the more freely they float, the less inflationary pressures of the sort described above will be passed through domestic prices. In the past two years, several Asian currencies have relaxed their tight links with the U.S. dollar, with the Chinese yuan and the Korean won at the forefront. While there is no doubt the yuan remains a tightly controlled currency, the Chinese government has broken with the fixed rate regime that delivered sustained growth for the prior decade. Importantly, the government has also demonstrated a resolve to reform its domestic financial system — an absolute requisite should the country aim to introduce a more market-based exchange rate mechanism. Meanwhile, the Korean won has exhibited far more flexibility than was historically the case. Though domestic policy still influences the currency's price, the won has left an artificially narrow trading range, appreciating over 20% during the last two years. Asia's slow but steady progress towards market-driven currencies is essential: without it, the region will find itself less free to set its own course for interest rates, and more dependent on global business cycles.

¹ IMF
² Bloomberg
3 IMF