February 7, 2011
Stephen S. Roach
Asia’s Inflation Trap
Asia has an inflation problem. The sooner
it comes to grips with its problem, the better.
Unfortunately, the appropriate sense of
urgency is missing.
Willingness to tackle inflation is impeded by Asia’s heavy
reliance on exports and external demand. Fearful of a
relapse of end-market demand in a still shaky post-crisis
world, Asian policymakers have been reluctant to take an
aggressive stand for price stability. That needs to change—
before it’s too late.
Excluding Japan—which remains mired in seemingly
chronic deflation—Asian inflation rose to 5.3% in the 12
months ending in November 2010, up markedly from the
3.5% rate a year earlier. Trends in the region’s two giants are
especially worrisome, with inflation having pierced the 5%
threshold in China and running in excess of 8% in India.
Price growth is worrisome in Indonesia (7%), Singapore
(3.8%), Korea (3.5%), and Thailand 3% as well.
$VLDKDVDQLQÁDWLRQSUREOHP7KHVRRQHULW
FRPHVWRJULSVZLWKWKLVSUREOHPWKHEHWWHU
Yes, sharply rising food prices are an important factor in
boosting headline inflation in Asia. But this is hardly a trivial
development for low-income families in the developing
world, where the share of foodstuffs in household budgets—
46% in India and 33% in China—is 2-3 times the ratio in
developed countries.
At the same time, there has also been a notable deterioration
in underlying “core” inflation, which strips out food and
energy prices. Annual core inflation for Asia (excluding
Japan) was running at a 4% rate in late 2010—up about one
percentage point from late 2009.
A key lesson from the Great Inflation of the 1970’s is that
central banks can’t afford a false sense of comfort from any
dichotomy between headline and core inflation. Spillover
Note:7KLVHVVD\ZDVSXEOLVKHGRQ-DQXDU\E\Project SyndicateDQGGLVWULEXWHGWRWKHLUJOREDOQHWZRUNRIQHZVSDSHUVPDJD]LQHVDQGRWKHUPHGLDRXWOHWV
Morgan Stanley Asia
effects are inevitable, and once a corrosive increase in
inflationary expectations sets in, it becomes all the more
painful to unwind. The good news for Asia is that most of
the region’s monetary authorities are, in fact, tightening
policy. The bad news is that they have been generally slow
to act.
Financial markets appear to be expecting a good deal more
Asian monetary tightening—at least that’s the message that
can be drawn from sharply appreciating Asian currencies,
which seem to be responding to prospective moves in policy
interest rates. Relative to the US dollar, an equal-weighted
basket of 10 major Asian currencies (excluding Japan) has
retraced the crisis-related distortions of 2008-2009 and has
now returned to pre-crisis highs.
%XW$VLDLVUHOXFWDQWWRWLJKWHQPRQHWDU\
SROLF\WRRDJJUHVVLYHO\³IHDUIXOWKDWFXUUHQF\
DSSUHFLDWLRQZLOOXQGHUPLQHH[SRUWOHGJURZWK
Export-led economies, of course, can’t take currency
appreciation lightly—it undermines competitiveness and
risks eroding the country’s share of the global market.
It also invites destabilizing hot-money capital inflows.
Given the tenuous post-crisis climate, with uncertain
demand prospects in the major markets of the developed
world, Asia finds itself in a classic policy trap, dragging
its feet on monetary tightening while risking the negative
impact of stronger currencies.
There is only one way out for Asia: a significant increase in
real, or inflation-adjusted, policy interest rates. Benchmark
policy rates are currently below headline inflation in India,
South Korea, Hong Kong, Singapore, Thailand, and
Indonesia. They are only slightly positive in China, Taiwan,
and Malaysia.
The lessons of earlier battles against inflation are clear on
one fundamental point: inflationary pressures cannot be
contained by negative, or slightly positive real short-term
interest rates. The only effective anti-inflation strategy
entails aggressive monetary tightening that takes policy
rates into the restrictive zone. The longer this is deferred,
the more wrenching the ultimate policy adjustment—and
its consequences for growth and employment—will be.
With inflation—both headline and core—now on an
accelerating path, Asian central banks can’t afford to slip
further behind the curve.
Asia has far too many important items on its strategic
agenda to remain caught in a policy trap. This is especially
true of China, whose government is focused on the pro-
consumption rebalancing imperatives of its soon-to-be-
enacted 12th Five-Year Plan.
Much is made of Asia’s Teflon-like resilience in an otherwise
tough post-crisis climate. Led by China, the high-flying
economies of developing Asia are increasingly viewed as the
new and powerful engines of a multi-speed world. While
the jury is out on whether there has really been such a
seamless transition of global economic leadership, Asia must
face up to the critical challenges that may come with this
new role. Inflation, if not addressed now, could seriously
compromise the region’s ability to meet those challenges.
Stephen S. Roach, a member of the faculty of Yale
University, is also Non-Executive Chairman of Morgan
Stanley Asia and author of The Next Asia (Wiley 2009).

$VLD
VJURZWKVWUDWHJ\PXVWVKLIWIURP
H[SRUWWRFRQVXPHUOHGJURZWKLQÁDWLRQ
FRQWURO³DQGPRQHWDU\WLJKWHQLQJ³
LVHVVHQWLDOIRUWKLVFULWLFDOWUDQVLWLRQ

So far, the Chinese leadership has adopted a measured

approach to inflation. Its efforts focus mainly on increasing
banks’ mandatory reserve ratios while introducing
administrative measures to deal with food price pressures,
approving a couple of token interest-rate hikes, and
managing a modest upward adjustment in the currency.

The mix of Chinese policy tightening, however, needs to

shift much more decisively toward higher interest rates.
With the Chinese economy still growing at close to 10%
per year, the government can afford to take more short-term
policy risk in order to clear the way for its structural agenda.

Indeed, China’s dilemma is emblematic of one of

developing Asia’s greatest challenges: the need to tilt the
growth model away from external toward internal demand.
That can’t happen without increased wages and purchasing
power for workers. But, in an increasingly inflationary
environment, any such efforts could fuel an outbreak of the
dreaded wage-price spiral—the same lethal interplay that
wreaked such havoc in the United States in the 1970’s. Asia
can avoid this problem and get on with the heavy lifting of
pro-consumption rebalancing only by nipping inflation in
the bud.


This communication is not a product of Morgan Stanley’s Research Departments
and is not a research report but it may refer to a Morgan Stanley research report
or the views of a Morgan Stanley research analyst. We are not commenting on the
fundamentals of any companies mentioned. Unless indicated, all views expressed
herein are the views of the author’s and may differ from or conflict with those of
the Morgan Stanley’s Research Departments or others in the Firm. For additional
information, research reports and important disclosures, see https://secure.ms.com.

The information provided herein has been prepared solely for informational
purposes and is not an offer to buy or sell or a solicitation of an offer to buy or
sell the securities or instruments mentioned or to participate in any particular
trading strategy. This information is based on or derived from information generally
available to the public from sources believed to be reliable. No representation
or warranty can be given with respect to the accuracy or completeness of the
information, or with respect to the terms of any future offer or transactions
conforming to the terms hereof.

This report does not provide individually tailored investment advice. It has been
prepared without regard to the circumstances and objectives of those who receive it.
Morgan Stanley recommends that investors independently evaluate particular
investments and strategies, and encourages them to seek a financial adviser’s advice.
The appropriateness of an investment or strategy will depend on an investor’s
circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell
any security or to participate in any trading strategy. The value of and income from
your investments may vary because of changes in interest rates or foreign exchange
rates, securities prices or market indexes, operational or financial conditions of
companies or other factors. Past performance is not necessarily a guide to future
performance. Estimates of future performance are based on assumptions that may
not be realized.

Permission from Morgan Stanley is required before republication of this essay.

Contact: Noel Cheung at Morgan Stanley Corporate Communications at
(852) 2848-6788 or noel.c.cheung@morganstanley.com

© 2011 Morgan Stanley. All rights reserved.

www.morganstanley.com