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Should we worry less about inflation in developing economies than most investors do? I think so--because inflation is different in these economies
12/21/2010 3:54 pm EST
The inflation story in the world’s developing economies is very different. There inflation will run at, Morgan Stanley calculates, 5.4% in 2010.
You know what inflation of 5.4% would mean in the United States, of course. The Federal Reserve would be in high alert, raising interests rates, jawboning Congress about cutting spending. Traumatized bond investors would be staring at Treasuries that sank in price and rose in yield every day. And anything that offered an ounce of inflation protection—gold, commodities, commodity stocks—would be as valuable as, well, gold.
But does inflation in the world’s developing economies deserve the same response? Financial markets talk as if they’re determined to impose the same kind of discipline, threatening to abandon Brazil and Turkey, for example, unless they demonstrate a commitment to financial restraint. Developing world central bankers, most of them trained in developed world universities, crank out the weapons of the Federal Reserve and apply them to their own economies. Brazil, India, and China have all raised interest rates this year.
In Brazil inflation climbed at a 5.63% annual rate in November and economists are projecting 5.88% in 2010 before a decrease to 5.29% in 2011. India just saw its first decrease in producer prices—the Reserve Bank of India’s preferred inflation measure—in 11 months in November, but inflation by this measure is still running at 7.48%. And in China consumer price inflation accelerated to 5.1% in November.
And investors? Developed world investors cluck their tongues and maybe decide not to invest in developing countries where inflation is running at 5%. Or horrors, 5.5%. Investors from developing economies seem even more sensitive to inflation worries: Those worries are the major driver of the Shanghai stock market right now. Every investor, whether based in a developed or developing economy worries about the chance that high inflation will call the wrath of the central bank down on these economies. I know. I express that worry myself in these posts.
But I think that reaction is too simplistic. Inflation, if you think about it at all, operates differently in developed economies like the United States is now and developing economies like the United States once was. And maybe investors need to keep those differences more clearly in mind when they’re deciding where to invest.
Lets start with one of the quaintest notions of developed world inflation measurement: Price increases in food and energy don’t count. Yes, the price of milk and fuel oil show up in the headline inflation numbers, but “real” economists, “real” financial journalists, and, certainly the “real” central bankers who work at the Federal Reserve know these categories don’t count. They watch something called “core inflation,” which intentionally doesn’t include these categories.
But in developing economies food price inflation is often the most important inflation. For example, when Felipe Calderon took over as Mexico’s president in 2006 he faced an immediate inflation crisis. Rising corn prices had pushed the price of a corn tortilla to a 10-year high. No joking matter since tortillas are a mainstay of the Mexican diet and the cost of a kilogram of tortillas had climbed to one-fifth the daily minimum wage. Calderon applied pressure and got an agreement from Grupo Bimbo and Mexico’s tortilla retailers to reduce the price to 8.5 pesos per kilogram, or less. That was about 2.5 pesos below the high market price.
Food is a key component of inflation on Mexico and other developing countries. Inhabitants of countries with lower per capita incomes spend a bigger portion of those incomes on food. Food makes up about 23% of Mexico’s consumer price index. In Brazil food makes up 27% of the index. In China it’s 33%. India 46%.
As national incomes rise, family spending on food, as a percentage of that income, falls. In the United States, food makes up just 15% of the Consumer Price Index. Food consumed at home makes up just 8.9% of the CPI headline inflation index. Add up medical care (at 5.3%) and the oddly grouped education and communication category (6.2%) and they outweigh food at home. In the United States transportation at 18.6% outweighs total food. And housing at 39.8% crushes all other categories.
So when we’re talking about inflation in the United States and inflation in a developing economy such as Mexico or China, we’re really trying to compare apples and oranges. Inflation in the United States is dominated by housing prices (which government statisticians, oddly, estimate from rental equivalents). Inflation in a developing economy is dominated to the same degree by food.
Which right now, when global food prices are soaring thanks to tight food supplies and below average harvests, means high inflation in developing economies has a huge bearing on social unrest and domestic politics but may not reflect a general overheating of the economy in these countries. Price controls on food—such as China is trying--or export restrictions--such as India is trying--are perfectly reasonable and perhaps effective responses to food-driven inflation. (In both China and India, however, the economy is also seeing a huge level of asset price inflation—in real estate for example—which has nothing to do with the price of food and everything to do with money supply.)
At the least, I think, this means that investors need to accept more inflation volatility in developing economies as normal because of consumption patterns in developing economies. We shouldn’t run for the exits at the same relatively low levels of inflation that would signify a major problem in a developed economy.
That doesn’t mean, of course, that any investor should like to see inflation climb from 5% to 6% to 7%. But it does suggest that inflation of 5.9% in Brazil, for example, isn’t a huge problem if the government is taking steps to see that it comes down, rather than increases, in 2011.
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