Rising inflation has become problematic for emerging markets over the past year. But a slowdown in the pace of rising commodity prices is one of several indicators that, in our view, points to inflation reaching its peak in the summer.
Inflation intensified in 2011
Following the financial crisis in 2008, emerging markets initiated monetary stimulus and fiscal spending policies to recharge growth. By 2010, industrial production in many emerging economies had reached, and in some cases exceeded, levels prior to the crisis. Operating at or above capacity was one sign that inflation was around the corner.
Inflation became problematic in the second half of 2010 and intensified in 2011. Many emerging markets were wary about the sustainability of the recovery in an important export market — the United States. Fearing that the U.S. recovery was weak and watching growth slow in peripheral Europe, emerging markets were less willing to remove their stimulus policies and put the brakes on their own growth.
Commodities prices fuel inflation
Rising prices of food and energy, including oil, added to inflation. Food represents from 30% to 50% of the Consumer Price Index in most emerging markets. In China, food makes up about one third of CPI compared with about 50% in the Philippines.
In a developed country, raising interest rates is often used to slow inflation. In emerging markets, there is an added complication because higher interest rates may attract hot money flows from foreign investors. Hot money is short-term capital that moves in and out of countries quickly as investors seek to optimize returns. Many investors find emerging markets to be attractive as developing nations tend to have lower household, government, and corporate debt compared with developed markets. Emerging markets generally grow faster as well. Investors may also be seeking an additional benefit, believing that local currency will likely appreciate against developed markets.
But too much foreign hot money can have a harmful impact on an economy. For example, significant foreign investment in local real estate may cause property prices to escalate.
Concerned about these effects, some emerging markets have tried to avoid raising interest rates and relied more on other ways of controlling inflation such as raising reserve and capital requirements for banks, introducing taxes on foreign capital inflows, and setting loan quotas.
Inflation to peak
In China, there are some indicators that inflation may peak this summer, and that other emerging markets will soon follow. China has had success in decelerating its money supply and slowing down bank loan rates with its policies. Energy and food prices already have dropped somewhat from their highest recent levels. Expectations for global growth have declined since the beginning of the year, mostly for developed markets, signaling a less robust demand for all commodities.
Food prices may still be going up, but the pace is slower. In some cases, prices are going down. There are many reasons for this. In China, there had been sharp spikes in the prices of specific types of food such as garlic and cabbage. With agriculture being inefficient and fragmented, many farmers responded by planting larger quantities of garlic and cabbage. The result: oversupply and lower prices.
Emerging markets better positioned to beat inflation
The fears that many investors had at the beginning of the year, that emerging markets broadly were overheating and would not get inflation under control, did not materialize.
In my view, the probability of a hard economic landing — a major growth slowdown for emerging markets — is rather low and very unlikely. Indeed, if growth falls more than expected, policymakers in emerging markets have more flexibility to take action than their counterparts in developed markets. They can reverse course and put their foot back on the accelerator of stimulus. These countries have the healthy corporate, bank, and household balance sheets to affect change. They have more tools to use than developed nations.
International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility.