Asia faces multiple policy dilemmas

As policymakers globally grapple with soaring food prices, Asia seems to have an added problem on its hands, that of rising inflation threatening its policy credibility, its asset markets and its currencies.

Economists say Asia's inflation monster has become so large that it is worrying foreign and domestic investors and turning conventional wisdom on its head.

Just a few weeks ago analysts predicted that most Asian currencies would rise in the months ahead, given a green light from authorities willing to use currency gains to cap costs of imported food and fuel.

But prices have gone up so much that now policy makers are forced to defend their markets from capital flight spurred by growing doubts about their econ-omic management.

Currencies and stock markets are falling in Indonesia, India, Vietnam and the Philippines - countries perceived to be most at risk of losing control over inflation. Foreigners have sold a net $12.4 billion of Asian shares in the past 12 weeks.

"It is becoming increasingly difficult to say that currencies will appreciate as a policy choice because of inflation," said HSBC strategist Daniel Hui.

"It's getting to a point where the vulnerability on currencies is for depreciation on account of inflation rather than the other way around."

Investors got a scare recently when Indonesia's stock market fell to a seven-month low after a spike in inflation, reminding them of August 2005 when a spurt in inflation caused the rupiah to collapse.

Even though economists believe Indonesia's central bank has a much better hold grip on policy now, it is taken to task by investors, along with South Korea, the Philippines, Vietnam and India, for doing too little, too late to curb inflation.

Indonesia's stock market has fallen 18 per cent this year, Vietnam's is down 42 per cent and India's 22 per cent. The Philippine peso has fallen 4.8 per cent against the dollar this year.

The policy dilemma is a familiar one. Torn between containing inflation or propping up growth hit by the wider credit crisis, many of Asia's central banks have succumbed to political pressures and opted for a pro-growth policy.

That has meant interest rates have been kept too low even while food prices soared and global oil prices nearly doubled within a year.

Inflation is running above official target ranges in China, Korea, the Philippines, Singapore, Taiwan and Vietnam.

Indonesia's benchmark one-month rate is eight per cent, below the March annual inflation of 8.17 per cent. Vietnam's base interest rate of 8.75 per cent is less than half the inflation rate of nearly 20 per cent.

Real interest rates, adjusted for inflation, are negative in China, Vietnam, Singapore and China.

That spells trouble for countries whose inflation-fighting credentials are still shaky. Rapidly rising prices erode the value of money, forcing domestic investors to divert money from low-yielding bank deposits into fast-appreciating assets such as property.

There are already signs that surging import costs are eating into trade surpluses that have cushioned Asian currencies, and inflationary expectations are spreading to wages, rents and other sectors, possibly boding ill for growth.

"Policy response throughout the region has been slow and realistically speaking inadequate to fight the upward pressure on prices," said State Street's econ-omist Dwyfor Evans.

So, rather than belatedly raising interest rates, authorities have resorted to fiscal measures. Indonesia has lowered import duties on some food items, India has cut import tariffs and even banned rice exports. Both countries already subsidise fuel.

China and Vietnam too have curtailed rice exports, while the Philippines is trying to import more.

Lost credibility

But financial markets haven't taken kindly to these measures, which to some underline the ineptitude of monetary policy and to others provoke concern fiscal deficits will rise in already indebted countries such as India and the Philippines. "If you are looking for an immediate cap on price pressures, food subsidies are the only immediate policy you have at your disposal," said Evans. "But that is not particularly liked by the markets, so these countries find themselves in a bit of a pickle here."

The Indian rupee is down 1.4 per cent so far this year, and the won and peso too have fallen. "We have come to this impasse where expectations are starting to price inflation in. So the last thing Asian countries need now is for currencies to weaken," said JPMorgan Chase's Claudio Piron.

The ones that stand apart in Asia are those with a reputation for managing inflation, such as Singapore, and those with deep pockets, ample reserves or current account surpluses to force their currencies higher such as Malaysia, Taiwan and China.

Singapore tightened policy last week by shifting up its secretive trade-weighted currency band. That sparked speculation other currencies in the region might appreciate, and the ringgit and won even rose against the dollar, albeit briefly.

But analysts point out that not all countries have Singapore's credibility or nimbleness. "The tail can't really wag the dog," said Barclays Capital's head of rates strategy Peter Redward.