Rising Inflation Rates

In what is being seen as a worrying phenomenon in the entire South East Asian region, inflation rates have shot up like never before. Countries like India and China have been at the butt of such astronomically high inflation rates. With the continuously rising oil rises to be primarily blamed for this state of affairs there have been demonstrations and protests by the masses all over these countries. In tune with this, China’s premier called the nations attention to a strong vigilance against inflation which he said ‘has reached 12-year high’. Meanwhile a state-run news agency, commented that the government would in all likelihood try to ensure that price increase in different quarters are accepted by the masses.China’s top economic official, Wen Jiabao tried to remind local officials that they should not be complacent about the rising inflation rates and take all necessary measures to control the situation in hand. Although fast developing nations, both India and China are rightly worried over the situation especially with the constant trend in rising fuel prices world wide.

Inflation rates in India jumped to 11.6% in late June, with the increase in sectors such as food, oil and cement prices, this in comparison to inflation rates at a 4.32% just a year ago.

Most economists and manufacturers in the area are concerned that if inflation continues to rise it will push up production costs and diminish the competitiveness of exports, leading to massive business loss.

However financial analysts are positive that the rates in the United States should come down soon, this is in reference to the fact that most Southeast Asian currencies are closely connected to the dollar. Speculations are on that Indonesia, Thailand, Philippines and Vietnam have also starting feeling the impact of inflation.

In a bid to reduce inflation rates the Malaysian Government has launched an anti- inflation drive. The bid tries to exert strict surveillance on excessive profiteering, liberalization of food imports, and warning that more goods will subject to price controls.

Confirmation of a high rate of inflation in Vietnam has been reported as well. Authorities in Vietnam conceded that the country had exceeded its full-year target of less than 10 percent inflation just in five months. Shortage of agricultural products, particularly rice in various countries, leading to floods, drought and poor condition of farm lands have given rise to more of such conditions.

Is Asia The Next Blue Chip?

Really, would you rather invest in the West, or Asia now? The US, as many lament with a sigh, is in trouble. The economy’s tanking; the property price crash has only just begun; the currency is a disaster; and equities aren’t even particularly cheap. Much the same is true of the UK, albeit less evident, and even the European markets we have long been keen on are beginning to look a bit bleak. Don’t touch them with a bargepole, say analysts at consultancy GaveKal: Europe is starting to experience “the full effects of higher taxes, higher interest rates and a higher exchange rate”. This is a combination that is “usually enough to floor even the toughest economy (which Europe is not)”.

So what’s an investor looking for a safe haven to do? Some analysts suggest buying and holding your gold ounces. But much of the rest of the market has a rather different take on things. Buy Asia, says GaveKal, and specifically “Asian equities and real estate”. Why? Because Asia’s economies and markets have now finally “decoupled” from the US - they have developed to the extent that they are no longer dependent on US growth to drive their own growth. This, say the bulls, is the dynamic behind the way the regions’ stockmarkets have entirely shrugged off the credit crunch: the MSCI emerging markets index is currently trading at an all-time high, while the MSCI BRIC index (which tracks stocks in Brazil, Russia, India and China) is now trading 6% above even its pre-crunch peak.

So exactly how real is this decoupling? Much of the data seems to back the idea. Consider the most recent trade numbers from the US. Exports are currently rising at more than 14% on an annual basis, while imports are rising at only 5%. Export growth is nearly three times import growth and total exports (which have long been around only half of total imports) now equal 70% of total imports. This, as Jim O’Neill of Goldman Sachs points out in the FT, “is almost unheard of in the US” and it tells us something absolutely vital to our understanding of the global economy.

Those who are bearish on global growth as a whole say that if the US consumer gives up the ghost (as he or she looks to be about to do) “the end of the world is nigh”. But these numbers - which show us that even as the US consumer is cutting back, the rest of the world is stepping up to the consumption plate - say it isn’t. “The world is changing” and global growth is no longer led by just the US. There are many other figures to back this up. In July the IMF raised its global growth forecast for 2007 from 4.9% to 5.2% on the basis, in part, that emerging markets’ economies were proving stronger than expected in the face of a weakening US.

On their forecasts China, India and Russia between them will now account for half of global growth this year. Then look at the actual consumption numbers in China: Chinese retail sales grew 17.1% in July and, says O’Neill, are now “contributing as much to the world” as those in the US. Brazil, Russia and India are seeing double-digit sales growth, too: add their sales to China’s and their consumer spending growth is around 10% - twice that of the US.

Overall, the Brics between them make up 15%-16% of GDP. That may be half that of the US but it’s growing a lot faster and that, say the bulls, is key. Do the numbers in the same way as the analysts at Goldmans and you will see that to July of this year the growth in consumption in the Brics contributed nearly 1% to global growth. In the US it contributed only 0.7%. The point? Incremental consumer demand from the Brics is greater than that of the US for the first time.

And that, says Hamish McRae in The Independent, is “a huge turning point” for the very simple reason that it suggests that even with a US recession “the world could conceivably keep growing”. Goldman is in full agreement on this one. “Our latest leading indicators show that if anything China’s (growth) might even be accelerating,” and there is nothing about that that looks as though it could change the country’s “major underlying longer-term positive dynamic force, namely, urbanisation”. Their conclusion? “Thank God for China.”

But is it really this simple? We write about Asia a lot in MoneyWeek and will happily agree that it is a very different place to the Asia of 1998. There are no more huge current account deficits and no more overvalued fixed currencies; corporate debt appears to be under control; growth is on an upward trend (about 5.5%), while inflation and interest rates are low (an average of 4.4% compared with a mid-crisis level of more than 15%) and better still, in the past five years most Asian countries (India aside) have been running current account surpluses - and healthy ones at that. However, none of this means that Asia is immune to US recession. It isn’t. Look at the numbers a different way - Michael Kurtz’s way, perhaps.

Kurtz, who is Bear Stearns’ equity strategist for Asia, doesn’t buy the decoupling story. Why? Primarily because we can’t really be sure of the extent to which local demand has actually risen across Asia. Much is made of the fact that China has become a growing destination for exports from the rest of the region, but a huge number of these exports don’t end their days in China. Instead, they just stop there to make their way up the value chain: they arrive semi-finished, get finished and are then “re-exported from China to developed markets”. So the fact that other Asian countries now export a lot more to China and a lot less to the US than they used to tells us nothing about Asian resilience to US recession. Note that Thailand’s exports have already dropped back: they grew at 18% in June but only 6% in July and August. Malaysian exports actually fell in June and July as weak US demand cut shipments of electrical and electronic goods.

It’s also worth pointing out, says Kurtz, that while consumption is rising fast in Asia and is contributing to global growth, “even in the richly populated economies of China and India its absolute magnitude is simply too small yet to offset any sizable US consumption slowdown”. Chinese total spending is only equivalent to 10.9% of US spending. And Indian spending in total is only equivalent to 5.6%. “There will eventually come a day when emerging Asia’s consumers punch in the same weight class as their developed world counterparts, but we’re not there yet.”

The basic point here is that it doesn’t matter how you cut it, Asia remains heavily dependent on exports and in particular on the overextended US consumer: the US still accounts for one fifth of Chinese exports. Sure, the impact of slowing American growth might be lower now than it would have been five years ago (when the general assumption was that every 1% change in US growth affected Asia by 2%) but it is still there and it hasn’t been, as Morgan Stanley puts it, “stress-tested” yet. Global growth has been great for years - we haven’t had such a good run since the early 1970s. But while the growth records of emerging economies are bound to beat those of the developed world, that hardly means they are now immune to the global business cycle - nowhere is. And we should also be careful not to buy too heavily into the idea that Asia is a completely changed place. Much improved, yes. But perfect? No. Morgan Stanley points out that although “abundance has bought stability and good growth to emerging economies, it has also brought complacency among policy makers”. Much of Asia still suffers from a lack of human capital, from inadequate infrastructure and in particular from an inadequate regulatory environment, with a lack of genuine competition. The latter should be of particular concern to equity investors as Joe Studwell points out in his latest book Asian Godfathers: a small group of billionaires control vast numbers of Asia’s listed stocks and are expert in making sure that the proceeds of growth accrue to some shareholders more than others.

None of this is to say that Asian markets won’t make fabulous investments over the long term: relative to markets in the west they almost certainly will. It is just to say that it might be premature to think that Asia will be a medium-term safe haven if the US really does go belly up. That said, there may be good reason to think that, despite the fact the decoupling argument doesn’t quite stand up for now, Asia may be a brilliant short term investment, too. In this week’s City View, Simon Nixon explains why investors should be able to make money on the region’s currencies, but Christopher Wood of CLSA also makes a good case for the region’s equity markets to perform well in the near future. As a result of Fed-led central bank easing, he says, the market will be looking for a new place to build a bubble. And given the near-consensus on decoupling, the obvious place for the “next bubble to form” will be in Asian and emerging market asset prices and “related commodity and natural resources plays”.

A common Asian currency: Stronger financial resilience?

Asia is hit badly by the current recession in the United States. Investors are shying away, stock markets are down, thousands are losing jobs.

In this scenario, there is once again talk of evolving a common currency for Asia for safeguarding its financial stability. But there are many hurdles on its way.

One is the `hegemony’ of stronger states. Smaller Southeast Asian states feel threatened by China’s growing economic power and Japan’s isolationist economic policy. They also question whether the currencies of Australia and New Zealand should be included with India. Japan is not too comfortable with China’s emergence and the fact that the yen may be overshadowed by the yuan. India too has been so far cool to the proposal for a common ASEAN currency, holding that it would require more coordinated efforts on the parts of all the participants and removal of many political and technical obstacles.

Some argue that it is impossible to replicate the euro experience because Europe had sorted out the question of hegemony long before the question of a single currency was mooted. The ideal preconditions that existed in Europe prior to the introduction of the euro either don’t exist in Asia or are only emerging. There were several factors that bound the European nations together. They included high trade interdependencies, Common acceptance of basic political and social values, fairly even economic development and comparable living standards. Even with common objectives, it took half a century for Europe to achieve a single currency.

There are a few such binding factors among Asian countries.However, conditions for a common Asian currency are improving. The past few years have witnessed higher trade interdependencies in East Asia than ever before. Trade volume among the ASEAN countries has swelled. Trade between India and China increased manifold over the past few years. foreign remittances from Japan and Singapore are on the rise.

But efforts towards a common currency have to be preceded by a common single market. ASEAN has already initiated steps toward evolving a mechanism for exchange-rate stability for promoting financial stability in Asia. More steps remain to be taken toward creation of a unified currency structure in Asia.

The benefits of an eventual single currency are numerous. It will increase market transparency by making prices more easily comparable. Cross-border transactions will also become more attractive as market operators will no longer be exposed to exchange-rate risks, and costs associated with currency conversion will be eliminated.

Moreover, single currency will go a long way in promoting political union in Asia. But it will be a long-drawn-out process. Europe has worked towards political and economic integration for over 50 years before the birth of a single European currency in 2001.

Approving Glances on Asian Defensive Stocks

Telecoms, infrastructure and toll road companies are among the best defensive stocks for Asian investors who fear that the downturn since the start of 2008 is shaping up to be a full-blown bear market.Strategists and fund managers said utilities, traditionally seen as a low-growth safe haven in troubled markets, hold less appeal than in the past because of less favorable regulation and rising input costs.

“The sectors I would be focusing on would be telcos, pretty much across the space, and some infrastructure stocks, particularly the Chinese ones,” said Tim Rocks, equity strategist with Macquarie Securities.

The Hong Kong-based strategist said investors should favor infrastructure plays, particularly in China, including toll road operators Shenzhen Expressway and Zhejiang Expressway, and be wary of utilities.

“Regulatory regimes are generally tougher, so that companies aren’t being allowed to pass some price increases because countries are worried about inflation,” Rocks said.

“Even though they’re defensive in that their revenue line may not move that much, the problem is their costs are going up, so they may not be as defensive as it would initially seem.”

Asian telecoms carriers including Taiwan Mobile, Singapore Telecommunications, Globe Telecom in the Philippines and South Korea’s SK Telecom were other potential defensive plays, he said.

Investors are hunting for safe havens as Asian stock indexes have tumbled after Citigroup’s record loss and weak U.S. retail sales heightened fears of a U.S. recession that would cut global growth.

But investors who might in the past seek the stability and dividends of utilities need to take a closer look before buying Hong Kong utilities like CLP Holdings and Hongkong Electric, said Louis Wong, research director with Phillip Securities.

A recently revised Hong Kong regulatory agreement will lower the cap on potential returns “so their resilience or their function as a safe haven may be undermined,” he said.

The Hong Kong-based analyst instead favors infrastructure plays including China Communications Construction and China Railway Group which, he said, will benefit from multi-year, multi-billion dollar commitments China has made to communications and transport spending.

He also liked Hong Kong’s Link REIT, which rents retail outlets and parking spaces in the territory’s government-owned housing estates.

Apex Capital Management fund manager Tat Auyeung said he also held China Communications Construction, as well as Shenhua Group, China’s largest coal producer, because they are relatively immune to slowing global growth.

He also pointed to China’s top telecoms firms, China Mobile, China Unicom, China Netcom Group and China Telecom as likely to do better in a downturn.

“Conventional wisdom is to put the money into sectors where they have very little to do with the U.S. economy, more domestic-related names like infrastructure,” he said.

In India, stocks perceived as defensive include the locally listed arms of food and drug multinationals such as Nestle India, Hindustan Unilever and GlaxoSmithKline Consumer Healthcare, said Bhaskar Laxminarayan of Pictet.

The Asia chief investment officer of the Swiss bank, who declined to disclose its stock recommendations or holdings, said government-run banks like State Bank of India and Punjab National Bank were also seen as safe havens.

Given the continued risks to international banks and financial markets from the U.S. subprime meltdown and global credit crunch, investors may simply be better off moving to cash or other asset classes, said Kirby Daley, strategist with Fimat.

“Investors have to think outside the box in this period where we’re entering uncharted territory. Simply moving to defensive stocks or buying on dips in equities is not necessarily going to be prudent,” he said.

Yet some strategists think crowding into defensive stocks, if such a category exists, would be a mistake given this is where the herd is moving.

“Fear has taken over, and really what you should be doing is going and buying those high beta risky stocks that have been driven down very hard,” said Adrian Mowat, chief Asia equity strategist at JPMorgan in Hong Kong.

“I wouldn’t be giving people a list of defensive names,” he said. “It’s a hedge against a bull market, and you own equities because your expectation is equities are going to go up.”

Understanding Asian currencies

With the US dollar reaching new lows versus hard currencies, many are waiting for Asian currencies to catch up. Why hasn’t this happened, and will it happen? The short answer is: it might, but be patient and don’t bet your farm on it.

To understand Asian dynamics, let’s first look at Europe. Remember how many ridiculed European growth earlier this decade? A key factor was the refusal of the European Central Bank (ECB) to jump on the growth bandwagon. As a result, consumer savings went up in Europe, while they headed down in the US. While the US economy became increasingly dependent on credit expansion, consumer spending and inflows of money from abroad to support its current account deficit, the euro-zone was far more balanced.

Asian governments tend to be interested foremost in social stability through economic growth. As a result, Asia facilitated the growth in the US, providing what seemed liked an unlimited amount of cheap labor. A weak or fixed exchange rate versus the dollar was one of the means to provide competitive exports to the United States. Foreign direct investment (FDI) in Asia skyrocketed, and Asia produced - a lot. As the supply of Asian goods flooded US markets, prices of US consumer goods remained low. American consumers neither had to pay more for goods, nor could they really afford to as their real incomes were under pressure: American manufacturers had to accelerate their outsourcing to Asia to remain competitive, thus keeping a lid on US wage inflation.

Asian countries were in no mood to allow their currencies to float higher, as it was considered key to their competitive advantage. Almost solely focusing on production, the amount of goods and services sold to the US far exceeded what was bought. As a result, Asian countries started building up massive US dollar reserves.

With the US and Asia fostering growth at any cost, commodities got ever more expensive; someone had to pay to produce this global oversupply. Because of the immensely competitive environment within Asia, a lot of the margin pressure was absorbed through investment in ever more efficient and scalable production facilities. China emerged as a clear winner in this race to produce; China’s market share of Asian trade with the US exceeds 30% and is growing. China now has the managerial know-how, skills amongst the workforce and infrastructure to implement large-scale production facilities. No other country even comes close.

This scalability will be crucial because the American consumer is threatening to spoil the party. As American consumers are out of cash and access to credit is increasingly difficult, they might just be buying less of those Asian imports that they don’t really need in the first place. Asian countries are in a precarious spot because over-production at home has made them vulnerable to a slowdown. This vulnerability is exacerbated as downward pressure on the US dollar has increased: if Asian countries allow their currencies to float higher, exports to the US become even less competitive.

US cure won’t work
The “cure” advocated by US policymakers to pressure Asian countries and currencies won’t do the trick, though: the US would like Asian countries to stimulate domestic consumption to reduce the trade imbalance and thus ease the pressure on the currencies.

Some Asian countries, with South Korea taking the lead, are indeed starting to take measures to stimulate their domestic consumption as exports to the US abate. However, this may not help the US dollar: while Asians love many US brands, these tend to be manufactured in Asia. And it is unlikely that the US will produce, say, sneakers, and sell them to Vietnam. At the same time, some of the goods produced in the US that Asia may want, such as military and nuclear technologies, the US is reluctant to export.

One scenario is that some Asian countries may engage in competitive devaluation to continue to sell to American consumers. There is no sign of this yet, but the risk cannot be ignored, especially among those with weaker competitive positions. Another possibility is that Asian countries will count on intra-Asian trade and domestic consumption to pick up the slack from falling exports to the US. Indeed, intra-Asian trade has become substantial and the US will over time become a less critical trading partner. At this stage, however, much of intra-Asian trade still ends up on the shelves of Wal-Mart in the US as the final destination.

But there are more changes that influence the global economy: as of last summer, Asia no longer is an exporter of deflation, but of inflation. As it became ever more difficult to absorb the cost of higher commodity prices, Asian manufacturers were suddenly able to pass on higher costs. Aside from high commodity prices, the “unlimited” supply of cheap Asian labor suddenly isn’t so unlimited anymore: wages have been going up in many areas. While the migration to cities continues, factories are moving up the value chain to secure a viable business model and wage demands for more sophisticated jobs are steadily increasing.

China, again, is the best positioned: factories in the country are now moving to the regions where migrant workers used to come from. This bodes well for infrastructure investments within China but will also help develop the regions that were previously left out. We’re not suggesting China is without challenges: amongst others, transportation costs will increase as more remote areas are developed.

Within Asia, holding foreign currency reserves worth billions of US dollars, in the case of China worth over a trillion dollars, has also become a politically sensitive issue. While traditionally foreign currency reserves were considered a welcome cost to help build up the domestic infrastructure, ever more American-educated policymakers influence Asian monetary policy.

At first, the calls were to invest these reserves more strategically: investments to secure access to raw materials in North America, Latin America, Africa and Australia - in short, everywhere - have soared in recent years. But with the US dollar under pressure, pressure to invest these reserves more profitably have increased.

Sovereign wealth fund investments from Asia have made numerous headlines over the past year, some of them embarrassing to the managers: investing in Blackstone’s initial public offering only to see the investment plummet is bad publicity not welcome to senior policy makers at a sensitive time. While sovereign wealth funds will play a role in the global capital market, we expect that they will devote a lot of attention to domestic issues, such as investing in domestic banks where returns may be more stable and losses easier to keep from public scrutiny.

As inflationary pressures have risen in much of Asia, allowing currencies to rise would be an obvious solution. But what may be obvious to readers used to free-floating exchange rates, is a radical step to governments that cherish control. Ask any businessperson in Asia, and you will likely hear that they like fixed exchange rates. It’s far easier to conduct business not worrying about what your currency may be worth tomorrow.

However, as pressures may become too great at some point to ignore, some Asian governments have taken steps to prepare for greater exchange rate flexibility. While China gets most scrutiny for not moving fast enough to allow the yuan to appreciate versus the US dollar, the country has taken a very responsible approach by developing local expertise and markets to deal with great exchange rate flexibility.

Many have argued that China will allow its currency to float higher to combat inflation; others argue that China will only allow greater appreciation as a gesture of goodwill to the incoming US administration in early 2009. The wheels of politics grind slowly, but they do grind. Note that China is extremely wary of inflation as political unrest in the past was usually linked to inflation.

Japan warrants special attention. Japan is part of Asia, but unlike other countries in the region has a highly developed economy. Rather than inflation, deflation is Japan’s major concern. In the past, our view has been that the Bank of Japan (BoJ) will intervene should the yen appreciate too much. Currently, we have a special situation because there is a leadership vacuum at the BoJ. The outgoing governor retired, but parliament has not agreed on a successor. The deputy governor recently assumed the role of acting governor.

Just like at all central banks, officials are busy trying to contain the fallout from the credit crisis in the US. On this backdrop, the Japanese yen has been able to strengthen beyond what we would have deemed permissible to the BoJ in a more normal environment. However, we believe the Japanese economy can stomach a stronger yen. It remains to be seen whether and how the BoJ will act.

In the long run, Asian governments would be well served if they opened their markets further. Only if exchange rates are allowed to float freely will domestic bond markets have a chance to more fully develop. While the US may show the signs of a good thing taken too far, domestic bond markets are crucial in providing more stability to the local economies in the long run. The World Bank in conjunction with the International Monetary Fund is spearheading an effort to develop domestic bond markets in Asia; we applaud their efforts, but note that solid markets will take many years to build and require governments to cooperate.

Because Asian markets are not as developed, their markets remain vulnerable to fast money moving in and out of the region. Local stock markets make international headlines as thinly traded markets see large institutions leave during times of turmoil. Currencies also react, but typically with less volatility than the stock markets; currencies in Asia may also be influenced by activity of major corporations active in the country: the Indian rupee makes it to the currency headlines from time to time as large funds are shifted. Major currencies are also affected by the flow of funds, but the markets are huge and select players are unlikely to have a noticeable impact.

Asian currencies are subject to different dynamics from those affecting hard currencies. Hard currencies may be suitable for investors looking to diversify out of the dollar. Asian currencies are driven not only by fundamentals, but to a much greater extent also politics; this increases the risk in them, but also provides for opportunities. A basket of Asian currencies may be able to mitigate the risks associated with any one Asian currency.