‘Decoupling’ theory a cruel joke as stagflation hits Asia

As far as markets are concerned, "decoupling" has "proved a cruel joke" so far this year, as Matein Khalid notes in the Khaleej Times. Far from proving a safe haven, emerging Asia has fallen along with other global markets; having lost around 22% this year, the MSCI Asia ex-Japan index is back to its March lows. And it is unlikely to stop there.

The key worry is the resurgence of inflation and the prospect of a "new economic bust" as governments, which have hitherto been slow to tackle the problem, belatedly take "radical measures" to clamp down on the problem, say Chris Giles and Raphael Minder in the FT. In April, the region's consumer price inflation hit 7.5%, nearly a nine-and-a-half-year high; core inflation, stripping out food and energy, reached 3.8%, double the pace of a year ago. The latest year-on-year consumer-price inflation (CPI) figures for India, Indonesia and Vietnam are 11%, 10.4%, and 25% respectively. Singapore's inflation rate of 7.5% is at a 25-year high.

Because a larger proportion of disposable income is spent on basic necessities in Asia than in rich countries, higher energy and food have had a disproportionate impact. While energy is widely subsidised, food comprises an average 29% of emerging Asia's CPI basket (70% in Sri Lanka): it explained 63% of the region's inflation in the first three months of the year, according to JPMorgan.

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Asian governments' tendency to intervene in foreign-exchange markets to bolster export competitiveness by holding their currencies down has also engendered inflation. When central banks intervene they have to print money to buy dollars, boosting domestic liquidity a process that has intensified as the dollar has dropped amid lower US interest rates. Asia has "imported loose monetary conditions from the US", says Giles.

There has been an "ominous increase" in Chinese inflationary expectations, according to Stephen Roach of Morgan Stanley, while UBS says that real interest rates are 1.7% across the region. Authorities have "been in denial about inflation and it will take a lot" of monetary tightening to "catch up with inflation reality", says Anthony Chan of AllianceBernstein. The later they leave it, the greater the danger that they will have to clamp down hard, "creating a much more challenging environment" for global growth and the region's equity markets, as Credit Suisse puts it diplomatically.

And just as the prospect of an inflation-induced slowdown is undermining the notion that Asia can prop up global growth, this idea of economic decoupling is looking increasingly shaky in any case. The US downturn is spreading to Europe, presaging softer Asia-Europe trade flows following the same pattern in Asia-US trade, notes Citigroup. Consumer confidence and real retail sales have been dented by inflation. The slower global economy and rising raw material costs imply that earnings per share growth, still expected to hit 6% this year, is set to turn negative by the end of 2008.

Moreover, valuations are still above average, says Citigroup, with Asia's price-to-book-value ratio at around 2.1. A 13% fall would take this ratio back to the long-term average of 1.8. But given that 1.3 marked the bottom in the last two recessions and inflation is set to undermine valuations, the odds of the average price-to-book-value ratio being the bottom in this downcycle "are not good". Long-term investors eager to cash in on Asia's development should hold off for now.