Cost push inflation is back

Overview: The two worlds of inflationpp.3 - 4 Across the emerging world, rising food and energy prices are forcing many central banks to tighten policy. Some
believe it also makes a case for higher rates in the US. But two wrongs do not make a right! Because rates were
too low in good economic times does not mean they should be pushed too high in bad economic times!

Asia: Testing time pp.5 - 7 Rising inflation presents the most important threat to Asian economies. It is critical to differentiate between the
different sources of price pressure. The risk and cost of policy conflicts and misdiagnosis is high, and rising.

Middle East: Breaking the resource cursepp.8 - 10 Higher oil prices are providing the GCC with significant windfall gains. The absorptive capacity of the region is
increasing, but the 'resource curse' has not been broken yet.

FX: Asian REER update pp. 11 - 12 Most Asian REERs are below their pre-crisis levels. The exceptions are the INR, CNY, SGD and THB. We see the
long term positive fundamentals remaining in place. The theme of current account surplus currencies
outperforming deficit currencies has shone through well. The next phase of the more open economies being hit by
the global slowdown should weigh the most on the TWD, SGD and MYR.

Commodities: Crude oil demand destruction elusivepp. 13 - 14 Crude oil prices spike on USD weakness and geopolitical risks. Speculation is an issue, but not the only factor
driving up prices. Oil prices to remain high as demand destruction proves elusive.

Abu Dhabi: Turning black gold into gold p.15 - 16
Brazil: More good newspp. 17 - 18
China: After the earthquake pp.19 - 21
New Zealand: Too easy for comfort pp.22 - 23
Singapore: Juggling to soft land pp.24 - 25
Forecasts and Sovereign risk tables pp.26 - 30

The two worlds of inflation
Across the emerging world, rising food and energy prices are forcing many central banks to tighten policy. These pressures are more severe in some economies than others, with South Asia a particular worry, as seen from recent further tightening in India and Pakistan. Yet not all countries are resorting to higher rates. Some, like China, prefer tighter loan quotas, as they are fearful of attracting inward speculative flows if rates rise too far. But China, India and a number of other countries also need to face up to the issue of energy subsidies, as they continue to subsidise the full cost of higher oil prices from feeding through into their markets. Whilst credit crunch worries overhang markets in the West, firm growth and rising costs are pushing central banks across the emerging world to tighten policy. Across the emerging world, where growth is strong, interest rates have either risen or need to rise further. Whether it is South Africa, across South Asia, the Middle East or parts of East Asia tight or tighter monetary policy is needed. There is no argument.

East: not just inflation, but di-flation
Across Asia, whilst the immediate inflation threat should not be under-estimated or played down, di-flation may be a better description of the conflicting issues being seen across the region. For whilst inflation is evident in food and energy prices, there is still intense competitive pressure in many other areas. Although inflation appears to have only become a recent concern, the reality is that inflation has been an issue for some time, although not in the headline price indices.

In recent years, we have seen a combination of factors lead to low headline inflation and, in turn, relatively low interest rates, particularly in the West. Whilst headline inflation rates were low, there was inflation in terms of asset prices, particularly real estate. Yet given that central banks in the West had not kept monetary policy tighter amid the positive supply-side shocks, asset price inflation became evident. Some might argue that this means central banks should tighten policy in response to rising asset prices. But what it really suggests is that central banks should be aware of the impact of positive supply shocks and should have aimed to keep headline inflation lower. One could use a similar line of argument to suggest that governments should run fiscal surpluses in times of economic boom; cyclically adjusted. Now, we are seeing inflation in terms of rising food and energy prices. This poses big problems for not only central banks but governments across Asia, as rising food prices hit the poor.

Whether higher food and energy prices feed through into higher inflation depends crucially on wages, and to some degree on inflation expectations, and also on whether central banks accommodate the pick-up in inflation. If wages do not increase then rising food and fuel prices will reduce the amount of money that people have to spend on other items. This, in turn, would likely see retailers and corporates take any increase in costs, such as fuel, on their margins. Hence the di-flation word that is used currently across some Asian countries.

However, if one looks at manufacturing and other areas there is intense competitive pressure. Supply chain optimisation is taking place, as firms try and squeeze costs. According to US import price data, China is getting more expensive, though not the most important source of import inflation (Chart 1). However, if the CNY appreciates further, then goods coming out of China will become even more expensive. Yet, the goods in China are taking market share, displacing others. Overall, China has moved from being deflationary to being modestly inflationary in terms of what it produces. And in terms of what it needs and consumes, as the economy grows and income levels rise, it is becoming more inflationary.

But in the West, the situation is more different. Although cost push inflation is back, the financial and economic environment is very different. Yet, it is the rise in costs that has recently created a gathering bandwagon for higher interest rates in the West. The European Central Bank (ECB) talks tough, signaling a one-off rate hike, as does the Bank of England. Even the Federal Reserve has appeared more hawkish. We believe there is a genuine risk of higher rates in Europe and the UK, but we don't think the US can afford a hike any time soon, though it may like to be seen as ready - probably for the sake of lending support to the dollar. Although parts of the US economy are doing well, such as big firms, the export sector and many farmers, the fragile financial sector and poor prospects for consumers should still concern the Fed; the jobs data, in particular, strike us as key (Chart 2).
In recent years, CPI figures around the world should have been renamed China Price Indices, such was the impact of that country on global inflation. Strong deflationary pressures were exported. Faced with such a positive supply side shock central bankers in the West should really have had tighter monetary policies. They didn't. As headline inflation stayed low, asset price inflation was rampant.
Now we have a negative supply-side shock in the form of high food and energy prices.

Some believe it makes a case for higher rates in the US. But two wrongs do not make a right! Because rates were too low in good economic times does not mean they should be pushed too high in bad economic times!
Yes there has been a small rise in inflation expectations and that needs to be taken into account. But where are the rampant wage increases? After most people have paid their higher food and fuel prices they have little to spend! In this environment many firms will have to take higher energy costs on the chin, and see their margins squeezed. Higher rates in the UK or US now would hit hardest those unable to cope, whether small firms or hard-up households, and probably for no real gain.
Thankfully the Fed's mandate explicitly takes this into account, but not the Bank of England's or the ECB.

Politicians in the West should watch closely to ensure that central banks behave in a responsible way that merits their independence and their mandate.

Asia
Nicholas Kwan
Regional Head of Research, Asia, +852 2821 1013, Nicholas.Kwan@standardchartered.com

Testing time
Over the past few months, Asian central banks and finance ministries have been busy responding to the rising threat of inflation. This threat has been supercharged by sharp jumps in oil and food prices, and further complicated by the simmering risks of social discontent and economic decline. While we remain optimistic that Asia in general will weather the current storm relatively unscathed, there are growing risks that need to be avoided. In particular, governments need to differentiate carefully between the different sources of inflation and the different tools needed to address the problems. They also need to strike a delicate balance between price stability and economic growth. The risk of a costly misdiagnosis is high, and rising.
Different sources of inflation

From Korea to India, consumer price inflation has been rising since mid-2007, as shown in Chart 1. Driven by record high prices of oil and food, inflation in many places is now running at decade or historical highs. For instance, Singapore, traditionally the icon of price stability in the region, is now suffering from the worst inflation in more than a quarter of century, reaching 7.5% y/y or tripling the rate of less than a year ago. Vietnam, on the other hand, had inflation running at 25.2% y/y in May, the highest on record and also more than three times the rate prevailing a year ago.

While food and fuel are generally blamed for the latest jump in CPI across the region, there are more devils behind the surge. These have complicated the hands of central banks. First is liquidity. In fact, well before the latest impacts of food and fuel become apparent, many Asian economies had been suffering from (or enjoying) excess liquidity, both from internal and external sources. Until late last year, much of the impact from excess liquidity was a happy one - rising asset prices - mainly equity and partly property - with relatively stable consumer prices. This has made Asian investors wealthier, at least on the books, and borrowers more aggressive. While most central banks responded by tightening monetary policy and some by adjusting their exchange rates and regulation of capital flows, generally speaking there was a lack of urgency in dealing with the issue given its relatively benign impact on consumer prices. In fact, some central banks were even accused by vested interests of spoiling the party with 'unnecessarily' tight credit.

Fortunately, Asia's emerging asset bubbles started to deflate since last autumn, partly because of successive monetary tightening but also because of the global financial turmoil. The correction in Asian equity prices over the past six months, ranging from -15% to over 60% (see Chart 2), has helped to prevent bigger bubbles emerging, but it is not problem free. For some markets like Vietnam, sharp and deep decline in asset prices has undermined investor confidence and triggered large capital outflows, putting pressure on the currency and destablising the wider financial system. Of course, Vietnam's problem goes deeper than a simple bubble. The country requires broader monetary and fiscal measures to restore its macroeconomic balance, but its experience highlights the potential pitfalls of unrestrained asset inflation and reminds us of the need to keep liquidity in check.

Another related and potentially more damaging source of trouble are inflation expectations. Once unleashed, this animal could play havoc with economic stability by triggering a continuous adjustment of prices, especially wages.

Middle East
Marios Maratheftis Serene Gardiner
Regional Head of Research, MEPNA, +9714 508 3311 Oil Products Analyst, +9714 508 4039 Marios.Maratheftis@standardchartered.com Serene.Gardiner@standardchartered.com

Breaking the resource curse
Higher oil prices are adding to inflationary pressures throughout the world, but perhaps more importantly they are creating substantial risks to growth. This brings back memories of the 1970's oil price hikes and the inflationary spiral those created. Most significant economic recessions since the Second World War have been created by inflation. The world is right to be concerned. However, sentiment in the Middle East and in particular the Gulf Cooperation Council (GCC) countries, is different. Their economies are booming, and there is little of the concerns of the west here. Here are three things to bear in mind when one thinks about oil, the region and the future.

First, oil prices are inherently volatile, and in the past fast oil price rises were followed by a collapse, which brought GCC economies down with it. Despite the efforts of the GCC economies to diversify, oil prices remain important. Second, the ability of GCC economies to absorb the windfall gains is as important as the price level itself. Severely constrained absorptive capacity will limit the benefits of the boom. We measure that capacity by looking at four factors: education, technology, financial market development and the quality of institutions. On each of these measures, we believe, things are improving. Third, the abundance of resources is not a guarantee of financial success. Historically, resource rich countries have underperformed thanks to the 'resource curse'. Aware of this threat, the authorities are aggressively diversifying. This is, however, a long-term transition.

Asian Real Effective Exchange Rate (REER) Update
The two charts next page show the Real Effective Exchange Rates (REERs) for the key currencies in the region. It is useful to look at exchange rates from an inflation adjusted trade weighted basis as this is more of a meaningful measure for policymakers to look at when deciding policy. Also the figures below are directly comparable between countries because all the indices have been rebased to January 1996. We note the following key points:
1) Most Asian REERs are below their pre-crisis levels. The exceptions are the INR, CNY, SGD and THB. We see
the long term positive fundamentals remaining in place 2) The theme of current account surplus currencies outperforming deficit currencies has shone through well 3) The next phase of the more open economies being hit by the global slowdown should weigh the most on the
TWD, SGD and MYR 4) The biggest decliner was the KRW which is 19% down from the high set in July 2007 5) Normally an underperformer TWD REER performance now matches the MYR
First it should be noted that there is still room for long term REER appreciation in Asia. There are four currencies shown below where the REERs have risen to above the pre-Asia crisis level. These are the CNY, INR, THB and SGD. In the case of the PHP the recent worsening in the fundamentals and weakening of the currency follows a strong rally dating back to 2005.

Second the current account deficit currencies in Asia have been clearly the worst performers since mid-07. The INR and KRW have been leading the way in this regard, being followed by the worsening situation in the PHP. Meanwhile the MYR and TWD REERs have stayed more steady while the SGD has been well supported. In H208 however we expect the driving theme to be the impact of the global slowdown. We expect the focus be on punishing those currencies most exposed to total trade. This implies negative pressure on the SGD, MYR, TWD, in H2-08 while the KRW, CNY and INR may outperform in the region given their smaller exposure to global growth. Compared to the start of the year when we called for this switch in focus from c/a deficit vs. surplus currencies to those most exposed to a global slowdown the current worry is over inflation pressures. While these inflation concerns remain in place there will be a delay in the shift in focus onto externally exposed economies.

As we have been stressing for some time we expect Asian currencies to be affected by the impact of the US slowdown. We expect this to play out in Q4-08 to Q1-09 rather than immediately. In this context the key currencies which have been doing better so far (MYR, SGD and TWD) may become the underperformers in this environment given their exposure to total trade. China is also likely to slow, leading to a knock on impact on the region. Therefore we expect to see more REER weakness in these currencies, particularly if Singapore switches away from an appreciation bias for the SGD NEER.

The most dramatic mover since the middle of last year is without a doubt the KRW REER. From the peak in July 2007 it has lost 19% on this basis. It is therefore encouraging that policymakers are wary of tolerating more weakness given the knock on impact on inflation. Also note that the benefits of a weak currency on the trade balance are rightly seen as being less than in previous years. Korean goods are less commoditised than in years gone by due to rapid rises up the value chain.

Productivity growth has been outpacing that of the US for the last decade and so we still see the long term trend for the KRW REER to be up. However while government policy certainty remains an issue we are cautious on the KRW. Indeed it was only in late May that policymakers switched from a weak to a stronger KRW bias and this seems to only be because of the previous losses. For now we expect to see a range in USD-KRW between 1,000-1,050.
The TWD REER is also worthy of attention. In previous updates we have stressed the trend of a gradual depreciation trend in the TWD, in contrast to most other regional currencies which were trending higher. Now there may be a change in this trend given the structural changes expected over the coming years from the increased economic links with the mainland. The same kind of positive impact on the economy could be felt as that seen in Hong Kong, particularly from investment flows.
The Hong Kong dollar REER has now taken the place of the JPY at the bottom of the list. This is not a major surprise given the USD peg. Rising inflation has not been enough to counter this trend. The danger is that the loose nature of monetary conditions, with a weak REER and negative real interest rates, leads to a bubble type conditions in asset and other prices, which would eventually lead on to a bust. We stress that this is not currently the situation but the conditions are in place for overheating pressures to emerge. Given the peg to the USD there is limited flexibility for policymakers to deal with this potential problem. For now it is a case of watch this space. There needs to be very strong evidence that switching away from the USD is a better option than keeping it. Right now the case for a change is not strong enough in our view.
In his first comment on the USD for a long time, Federal Reserve Chairman Ben Bernanke said that the USD's decline had contributed to inflation and inflation expectations and that both the Fed and the US Treasury were watching foreign exchange market developments closely. He added that Fed policy, as well as the economy's underlying strength "will be key factors ensuring that the dollar remains a strong and stable currency." Such comments are likely to support the market view that the Fed will not cut interest rates further. He warned that higher inflation expectations could become "self confirming" and are thus a "significant" upside risk to price stability. Taken at face value, such comments are seen by the market as an attempt to jaw-bone the USD higher. More likely the Fed is just trying to push for a USD stability given it is an important part of managing inflation and inflation expectations. Moreover, his reference to the fact that both the Fed and US Treasury continue to monitor foreign exchange markets closely is an implicit threat that actual intervention may be used if such inflation expectations