On Asia

September 2004

Interesting Times

By Andrew T. Foster, Head of Research
Matthews International Capital Management, LLC

“[It is] misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight… high interest rates, that money has been easy.“
–Milton Friedman, “Rx for Japan: Back to the Future”

Comparative Interest Rates, Growth and Inflation

As a rule, we at Matthews do not speculate on interest rate cycles. We believe that capital markets are highly efficient in this regard: markets are constantly pricing in the likelihood of rate changes each moment of every day. Nonetheless, after three recent rate hikes by the Federal Reserve, we thought it would be useful to briefly review how Asia's current interest rate conditions compare to those found in the U.S.

	Current Central Bank Interest Rate	Change from 6/04(1)	Inflation(2)	Growth(3)	2Yr Currency Application vs U.S. Dollar(4)
China	5.31%	+0.00%	5.3%	9.6%	0%
Hong Kong	3.25%	+0.75%	0.9%	6.8%	0%
India	6.00%	+0.00%	2.2%	8.2%	5%
Indonesia	6.88%	-0.21%	6.7%	4.3%	-5%
Japan	0.15%	+0.00%	-0.1%	4.4%	9%
Malaysia	2.70%	+0.00%	1.3%	8.0%	0%
Philippines	6.75%	+0.00%	6.6%	6.2%	-8%
South Koread	3.50%	-0.25%	4.8%	5.5%	4%
Taiwan	1.38%	+0.00%	3.3%	7.7%	0%
Thailand	1.50%	+0.25%	3.1%	6.5%	1%
U.S.	1.75%	+0.75%	2.7%	4.7%	N/A
European Union	2.00%	+0.00%	2.3%	2.0%	24%

(1) The U.S. Federal Reserve began its recent rate hikes in June of 2004.
(2) Year-on-year change in the “headline” consumer price index.
(3) Year-on-year change in real GDP (latest historical quarter).
(4) Change in local currency exchange rate, relative to the U.S. dollar as quoted on 8/31/02.
Sources: Bloomberg, The Economist and Matthews International Capital Management
Data as of published date, 9/22/04

At first glance, Asia and the U.S. seem to have much in common. Both regions appear awash with liquidity: nominal rates are near record lows. Real interest rates (nominal rates less inflation) are hovering around zero, and are in some cases negative. The table at right provides comparative statistics on growth and inflation for selected Asian countries, the U.S. and the European Union.

In general, one might assume that low interest rates are indicative of very relaxed monetary conditions. Classic economic theory suggests that such “loose money” will put upward pressure on prices; central banks, seeking to preserve price stability, will be forced to raise rates preemptively to stem the incipient inflation. This scenario may have contributed to the Fed’s recent decision to increase rates.

Historically, U.S. rate hikes led to a nearly automatic reaction on the part of Asian central bankers to follow suit. However, thus far, events have unfolded in a different manner. With the exceptions of Thailand (which has undergone one modest rate hike) and Hong Kong (a special case*), most countries in the region have not raised rates in line with the Fed. More interestingly, South Korea and Indonesia have moved in the opposite direction—both reduced rates about one quarter point since the Fed first raised rates in June.

Why are Asian central banks seemingly quiescent in the face of rising prices, and why are Korea and Indonesia apparently courting inflation? There are many potential explanations, but in our opinion, Milton Friedman's statement sheds some light on the situation. It is quite possible that monetary conditions in Asia have been much too "tight" given the region's growth potential. Money is the lifeblood of an economy, and fast-growing economies require more of the stuff in circulation to keep up the pace of expansion. If a nation's money supply is not adequate to support its growth, rates may actually fall, as companies forgo raising capital when they see few growth opportunities ahead. Likewise, if prices are not rising, consumers may feel less pressure to complete purchases in the present; this also reduces the demand for money, again causing rates to fall. Perhaps this is why Asian central bankers are not moving in sync with the Fed-they may believe that reducing domestic money supply will choke off too much growth.

In this context, moderately higher levels of inflation may actually benefit the region. This is especially true given that most Asian countries have sought very stable exchange rates relative to the U.S. dollar. Over the last two years, most Asian currencies have only changed 8% (or less) versus the greenback. This is a relatively small trading band when one considers that the Euro rose 24% over the same period. In general, higher inflation is thought to debase a currency. But in the Asian context, rising domestic prices are the natural outcome of rapid growth. Given exchange rate stability, rising prices on Asian goods and services implies that the region is producing higher-value products (as measured in U.S. dollar terms). Whether one considers wages, hotel tariffs, room rents or fast food, rising prices in Asia are indicative of increasing wealth-a welcome sign in a region where many are still struggling to attain basic levels of consumption.

*Hong Kong’s rate increases are an obligatory con’s value is directly pegged to the U.S. dollar via a currency board) and its open capital account.