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Inflation: a new worry for emerging markets

The outlook for emerging markets is clouding over rapidly - following years of strong growth and the surge in commodity prices, inflation is back with a vengeance.

Amid all the worry about the effect of the credit crisis on emerging markets, another vital issue for the developing world has been overlooked, says FAZ.net. Following years of strong growth and the surge in commodity prices, notably food (in some countries, subsidies cushion the impact of higher energy prices), inflation is "back with a vengeance". In Ukraine, it has hit 26%, Sri Lanka's rate is 25% and Latvia's 17%. 

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The Bank of Turkey foresees a rate of 10% in the third quarter, while in China inflation remained above 8% in March and non-food inflation hit a seven-year high of 1.8%, a sign price pressures may be spreading beyond food, says Capital Economics. Meanwhile, Russia is showing signs of overheating, with nominal wages growing by 30% year-on-year; higher labour and food costs are underpinning inflation of 13.3%. Vietnam's boom has pushed inflation to 21%. Merrill Lynch is now forecasting inflation across emerging markets of 6.7% this year, a seven-year high. And according to JPMorgan, inflation in developing economies is around 3% above the average target ceiling. 

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Food prices have a much bigger impact on overall inflation in poor countries as food comprises a larger share around 50% in some states of household expenditure. Another problem is that some countries still peg their currencies to the dollar, while others, in order to bolster exports, have been loath to allow their currencies to rise, which would help temper inflation. So monetary conditions in many emerging markets have been too loose.

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Effectively importing loose American monetary policy has spurred demand and inflationary pressure and has further underpinned raw materials prices. The IMF is now worried that inflation expectations in Asia are becoming entrenched no wonder, given that "the message in the food price riots is that these workers will soon be fighting for much higher wages", as John Plender says in the FT.  

Burgeoning emerging market inflation "makes it unlikely" that the developing world can rely on domestic consumption to offset sliding exports as America falls into recession and Europe slows, as David Roche of Independent Strategy notes in the Wall Street Journal. That bodes ill for global economic health. The countries most exposed to commodity inflation, such as China and India, are "precisely the ones that the world economy now depends on for most of its growth", says Anatole Kaletsky in The Times

Emerging countries are now having to tighten monetary policy to tame inflation even though growth in their export markets is slowing and undermining overall growth. China, Brazil, South Africa and India have all raised rates recently, and tighter monetary policy, which hampers growth, is not good news for stocks; high inflation also erodes profit margins. 

JPMorgan has just cut its Asian index targets for this year to reflect the risk that central banks' ongoing response to inflation will squeeze domestic demand and investment. S&P's Alec Young, noting that years of strong non-inflationary growth have boosted emerging market valuations to developed country levels, reckons the inflation problem could result in an emerging market discount re-emerging.

Whether inflation or an American-led global growth slowdown ultimately proves the greater problem, the overall outlook for emerging markets is clouding over rapidly.

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