Asian Sovereign Ratings Could Suffer If Central Banks Don't Act Forcefully on Inflation

by: Research Recap

Standard & Poor’s says some Asian central banks may need to act more forcefully to address inflationary pressures.

The economic recovery in Asia has been surprisingly strong, and a few economies may already be running at full capacity. The gains in food prices may also be persistent as rising demand outstrips supply in developing Asia. And easy monetary conditions in the developed world affect Asia even if capital controls, implemented by some governments in receiving economies, mute their impact. Inflation expectations among consumers may rise swiftly if central banks tolerate inflation and raise interest rates too gradually, especially in economies where inflation had been high before the global slowdown. Central banks may need to tighten monetary policy decisively to avoid this. Consider the following:

In the interest of macroeconomic stability, some Asian central banks may have to stand ready to react much more forcefully to emerging inflation than they have so far.

If inflationary expectations escalate significantly, sovereign creditworthiness could suffer. As policymakers in Vietnam have realized, a loss of consumer confidence in stable inflation can lead to significant policy challenges for central banks. Risks to financial stability can rise as a result, even if economic growth remains strong. And once that confidence is gone, it’s always much harder to get back.

Nevertheless, we believe that developing Asia could see more aggressive monetary tightening before inflation can be checked. The combination of an economy operating with little spare capacity and plentiful domestic liquidity risks kindling inflation expectations. Consumers may be more inclined to interpret positive economic data or sharp changes in commodity and asset prices as pointing to higher future inflation. Monetary authorities, however, could reduce the likelihood of such developments by keeping nominal interest rates sufficiently high.

In some cases, addressing price concerns may require a more wide-ranging set of policy measures. This is especially so in places such as China, Hong Kong, Singapore and Taiwan, where expected returns from investments in property or other assets far exceed reasonable increases in nominal interest rates. Such circumstances have led some policymakers to implement measures specifically addressing certain asset markets.

(Excerpts from How Will Asian Sovereigns Respond Now That Inflation Is Back?)