Asia Insight

September 2006

What's In Your Basket?

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

Every serious investor keeps a wary eye on inflation. Returns on investment are undermined when sustained price increases give rise to a higher cost of living. You may be a disciplined, long-term investor – but if your dollar does not stretch very far, you may find that your patient efforts are not as rewarding as hoped.

Even as inflation is of critical importance to investors, it is a fairly abstract concept, especially relative to many other aspects of investment. Securities can be measured by their prices; balance sheets are denominated in dollars and cents; interest rates are set in percentage points. Inflation, by contrast, has no single, objective measure. Economic theory defines inflation as a sustained increase in the "general level of prices," but theory is largely silent on which prices on what products comprise that "general level."

In practice, participants often rely on a consumer price index (CPI), which purports to measure the changes in prices paid by consumers for "a representative basket of goods and services."¹ The primary aim of the "basket" is to develop a practical sense of what it costs to achieve a given standard of living. By measuring changes in the cost of this basket over time, one can infer whether inflation has boosted living costs too far, too fast – a key measure of whether inflation has done damage to an economy.

There are a host of technical details that underpin the construction of a good consumer basket, one which can credibly serve as a proxy for general price inflation. In essence, the goal is to track what real people are buying, and then weight the basket according to actual consumption patterns. In order to get an authentic picture of spending habits, most statistical agencies undertake extensive surveys in their respective jurisdictions. For example, the U.S. Bureau of Labor and Statistics surveyed over 30,000 individuals during a two-year period in order to construct the current American CPI basket.²

The proper construction of a CPI basket can be rather contentious.³ We won't address those issues here. The important thing to note is that a CPI basket can do more than just measure inflation: it can also reveal a good deal about the spending habits of the populace that it is designed to track. CPI baskets are only a crude tool for understanding consumer behavior; nonetheless, they offer a reasonably standardized way to examine spending patterns over time and across borders. In so doing, the baskets can offer investors an important glimpse into what is motivating real consumers – and perhaps insight into where those consumers and their wallets will be heading next. This is particularly true in the Asian context, where reliable data on historical consumption is often lacking, and where spending patterns are evolving rapidly.

In most Asian nations, save Japan, the notion of a proper "consumer basket" is a very new concept. For example, Thailand has only recently undertaken a thorough survey of consumer habits; very little reliable data on household expenditures is available prior to 2002. In similar fashion, India has not formally updated the constituents of its CPI basket since 1982. Meanwhile, China has never publicly disclosed the makeup of its basket. There are many reasons that Asian governments might not be forthcoming with data on CPI baskets. Collecting such information is costly.

Furthermore, governments that enact subsidies and price controls on key consumables often wish to hide the components of inflation away from critical observers. However, another factor is also at work: Asian governments, historically focused on promoting industrial growth, are only beginning to understand the importance of consumer behavior to their economies.

Even in Asia's wealthier nations, where CPI baskets are nothing new, substantial changes in consumption patterns have taken place over a relatively short time horizon. Table 1 shows how consumers have shifted their spending patterns over roughly the last decade, as measured by changes in national CPI baskets; "growing" categories (i.e., higher percentage share of household budget than in the past) have a positive sign, and "shrinking" categories are shown in the negative. The table demonstrates that on this measure, U.S. households have held relatively steady, with no major shifts between expenditure categories; no group has swung by more than two percentage points over the last decade.

By contrast, Asian consumers – even richer ones – are still in relative flux when it comes to how they allocate their household budgets. In particular, the "food and beverages" category has declined sharply in every case. In Japan, this has occurred because sustained deflation and increased trade have combined to lower domestic food prices. However, in most of the other Asian nations listed, the declining importance of food marks a steady shift away from basic subsistence-oriented items, towards more discretionary goods. Individuals are not necessarily consuming less food; instead, the value of the foodstuffs in their basket has diminished relative to other items consumed. Products such as mobile phones and computers (both captured under "communications") have been the beneficiaries of this shift. Amongst the richer nations, medical care and education have also captured a rising share of the Asian wallet.

Asia's less-developed economies may see even greater shifts in the future, as growing incomes combined with the introduction of new products and services will likely beget major changes in consumer preferences. India is an excellent example of this trend: Table 2 indicates that about 2% of Indian budgets are spent on transportation and communication, versus a range of 13% to 22% elsewhere. India is somewhat akin to the U.S. in the breadth and diversity of its geography; thus it is not unreasonable to expect that India will spend a higher portion of its budget on transport in the future. As and when this expenditure grows, markets for autos, planes, trains and transportation services will certainly emerge.

Meanwhile, only 3% of Indian budgets are spent on healthcare each year. Based on average per-capita income of about $750, this equates to a gross expenditure of about $23 per person, versus a range of about $700 to $2,500 for the other wealthier countries in the table (Thailand is closer to $150). Very little is spent now for a lack of means; but Indian consumers will undoubtedly aim for a higher, healthier standard of living. Over time, this will mean that Indian households will likely boost their medical expenditure, both in absolute and percentage terms. This in turn should unlock new markets in healthcare services, pharmaceuticals, medical equipment and health insurance. Ultimately, much of Asia's economic future will be determined by what consumers cram in their baskets – and where those baskets go, markets will assuredly follow.

¹ U.S. Department of Labor, Bureau of Labor Statistics, http://www.bls.gov/cpi/home.htm#overview.

² U.S. Department of Labor, Bureau of Labor Statistics, http://www.bls.gov/cpi/cpifaq.htm#Question_6.

³ For example, the proper treatment of housing costs has been a subject of debate; see the BLS website at http://www.bls.gov/bls/fesacp1120905.pdf for more details. “Hedonic” adjustments to the CPI, which attempt to distinguish changes in product quality apart from changes in price, have been a second source of controversy. For more information, please see http://stats.bls.gov/opub/mlr/1993/12/art4full.pdf.