Inflation in India may prove hard to bring down: Frederic Neumann

Though Asian economies in general have bounced back
remarkably from the downturn of two years ago, there are also big risks, reasons HSBC’s co-head of Asian economics research Frederic Neumann. The worry in India, more than anywhere else in Asia, is that inflation will prove very sticky and very
difficult to bring down, Neumann says in an interaction with DNA. Different countries require different monetary responses in this environment, and the right mix depends on the circumstances of the economy.  In India, he notes, “we need to see interest rates go up.” Excerpts:

On the economic outlook for Asia in 2011:
The region experienced a tremendous economic recovery: we estimate that output now is about 23% above the pre-
recession peak. We haven’t seen such a breathtaking recovery in Western economies. In 2011 too, growth will continue to be
robust across Asia; we’ve raised our GDP forecast again,
especially for smaller Asian economies.

Growth in Asia is being driven by strong consumption but also increased investment spending; in 2011, corporations will
increasingly expand capacity and drive growth, and a recovery of the US economy will help drive exports and benefit smaller Asian economies.

But there are also big risks. Recovery in Asia is driven by a tremendous monetary stimulus — both because of low interest rates in Asia and record inflows from the West as a result of Quantitative Easing in the West. Asia has to start to tighten
monetary policy; the seeds are otherwise being sown for
tremendous challenges in 2012 and 2013.

The first big byproduct of very low interest rates is inflation. We are very concerned about inflation, and it’s not just about food price inflation. This is a broader issue, and interest rates have to go up to prevent a rerun of the inflation explosion of 2008. Keeping rates too low for too long also risks generating asset
bubbles across the region. Credit growth has accelerated — not just in China but across the region, including in India.

Policymakers will not just have to raise interest rates but use other tools to cool down property markets and other asset markets. Nothing draconian, but just enough to stabilise the economies.
Strong investments this year will help drive growth across Asia, but again, keeping interest rates too low for too long risks driving excessive investments. We are concerned that by 2012 or 2013, we may end up with an investment bubble unless monetary policy is tightened over the next six months.

On the policy options in India to fight inflation:
Growth will be relatively strong in India this year: our
estimate is for 8.1% growth. But the worry is that inflation in India, more than anywhere else in Asia, will prove very sticky and very difficult to bring down. We forecast the RBI will have to hike interest rates by 125 basis points at the very least to
control inflation.

There’s always a big debate about how helpful currency appreciation is in combating inflation. We think it’s not as important a tool to bring down inflation in India. That’s because inflation in India is driven by too strong demand locally, not because of imported food prices or imported oil prices. The Indian economy isn’t very sensitive to the change in exchange rates; it’s a domestically focussed economy.

Different countries require different monetary responses in this environment; the right mix depends on the circumstances of the economy.  In India, we need to see interest rates go up.

On the risk of policymakers getting it wrong:
I’m very concerned that policymakers (across Asia) will not apply sufficient tightening to stave off the risk of further inflation, asset bubbles and excess investment. The price will not be paid this year, but in the more distant future. The overall impression I get from most central banks in the region is that they are still very cautious: they still don’t fully believe in the strength of the current recovery and therefore will err on the side of caution—which raises the risks I’ve talked about. The region is facing an unprecedented monetary stimulus; it’s time to withdraw the stimulus and that’s the hard part. Will they deliver: I’m not terribly confident.

On the risk of a ‘trade war’ and its likely impact:
There’s a serious risk that if Asian countries don’t appreciate their currencies more rapidly, there will be a lot of political demands in the US to impose tariffs, which would restrict trade flows. But it’s still an outlier risk: things could improve in the US. And even though the unemployment rate is still close to 10%, so long as it’s improving, we don’t see tariffs as a sure development. There are still a lot of hurdles that need to be passed: and even if the US Congress passes disruptive trade restriction, there’s still the question of whether they will be WTO-compliant or not. And US corporate and big multinational corporations have an interest in free trade.