REFORMS NEEDED TO COMBAT THREAT OF ASIAN DEFLATION / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

May 18, 2015 5:25 am

Reforms needed to combat threat of Asian deflation

Frederic Neumann

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It is easy to shrug off tumbling inflation across Asia as merely representing the collapse in oil prices.

 

But that is to ignore deeper and more pernicious reasons. Growth across the region continues to slow and traditional measures to stave off a slide into outright deflation appear to be losing their punch.

Yet two misconceptions hold sway. The first is that tumbling inflation readings are a temporary phenomenon. Steadying, or even slightly rising, crude prices, the reasoning goes, will push up inflation gauges by the second half of the year.

 

In fact, the two are allegedly connected: the fall in the cost of oil over the past nine months represents a windfall for Asia, which imports most of its energy. So headline inflation may fall for a while, but this should eventually be offset by a boost to growth and a consequent pick-up in broader price pressures.

 

The trouble is there are no signs that growth is benefiting from lower oil prices. By now, demand should have started to strengthen. Instead, the first quarter probably represented a new low in the region’s growth since the global financial crisis.

The real question should be: how much weaker would growth have been if oil prices had remained unchanged? The answer: a lot lower, possibly by up to half a percentage point in Korea, India and Thailand, where spending tends to respond more to changes in energy costs than elsewhere.

This hints at broader, structural factors weighing on Asia’s growth. After all, not only has headline inflation slowed sharply but core price pressures, which strip out energy costs, have declined as well.
 

Central banks have cut interest rates and injected extra liquidity into financial markets. Yet investment has failed to bounce back and consumers continue to curtail their purchases. Equity markets have rallied, but that in itself will not cure Asia’s growth malaise.

The second misconception is that the latest tilt towards deflation does not matter. The Bank for International Settlements in a recent paper noted that deflation is rarely associated with economic weakness. Since the second world war, the authors find, falling prices have often occurred during periods of robust growth. This has reinforced the impression among many that the region’s bout of declining price pressures can be safely ignored.

Far from it. As the BIS authors concede, if deflation coincides with a bursting asset bubble the effects on financial stability and economic growth can be highly destructive. And it is on this score that Asia looks a lot more vulnerable: not only has debt increased sharply in recent years, exposing borrowers that are counting on rising revenues and incomes to service their obligations, but property prices have had a spectacular run, often underpinned by speculative borrowing. Prolonged deflation, therefore, is bound to exert a drag on growth and, if asset prices take a tumble, could lead to escalating financial challenges.

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At the heart of the debate is the distinction between “positive” and “negative” deflation. The former is associated with leaps in productivity that preserve profit margins of companies even as prices decline. The latter is reflective of a drop in demand, thus harming company profits. In Asia, it is difficult to argue that a positive deflation shock is under way. True, falling commodity prices are good for profits, but these in large part reflect slowing demand.

Productivity growth, meanwhile, has slowed in recent years.

 

What, then, is to be done? It is tempting to think that further monetary easing will do the trick.

Alas, this has lost its punch amid already high levels of debt. Other measures need to be taken.

In the short term, extra fiscal easing would help. In addition, financial reforms are needed that allocate capital to more efficient uses.

In China, the crackdown on shadow banking has reduced risks but also left smaller companies, the engine of job creation, with little recourse to borrowing. In India, overburdened banks have been reluctant to pass on rate cuts to their customers.

Regulatory changes may be needed to allow financial institutions to at least temporarily shoulder more risk. That also means, however, that opportunities for private companies will need to be expanded, primarily by pruning the privileges of state-owned enterprises and opening more sectors to foreign investors.

A tall order indeed. But without such reforms, Asia risks sliding deeper into deflation and the dire consequences this entails.


Frederic Neumann is co-head of Asia economics research