Asian Nixonomics may spell subsidy-driven stagflation

 

Asian governments face two unattractive alternatives: run up bigger deficits by continuing to shield citizens from soaring energy prices, or start to withdraw subsidies, fueling inflation and political backlash

ASIAN governments from India to Malaysia, clinging to budget-busting fuel subsidies, may end up paying an even higher price: saddling their economies with an extended period of stagflation.

"Subsidies will come increasingly in the way of future growth," says Kalpana Kochhar, a senior adviser for the International Monetary Fund's Asia-Pacific Department in Washington. "Not passing prices through and keeping artificial price and wage controls never works."

Governments are being forced to choose between two unattractive alternatives: run up bigger deficits by continuing to shield citizens from soaring energy prices, or start to withdraw subsidies, fueling inflation and political backlash. Inflation has already reached decade highs throughout the continent and played a role in destabilising politics.

The result will be a combination of slower annual growth, amounting to 7.6 per cent in 2008, and accelerating inflation of about 6.3 per cent in East Asia, which excludes Japan and the Indian subcontinent, according to a July 22 report from the Asian Development Bank. The region averaged 8.4 per cent gross domestic product growth and 3.2 per cent inflation in 2004-2007, according to ADB figures.

The consequences for Asia "may prove more socially and politically noxious" than the currency crisis of the late 1990s, says Uwe Parpart, chief Asia economist and strategist for Cantor Fitzgerald Hong Kong Capital Markets. Unlike the region's rapid recovery in 1997-98, "there is no V-shaped exit from inflation, only a long and painful one," he says.

Nixon's Controls

The current Asian experience is reminiscent of the US after President Richard M. Nixon's wage and price controls were dismantled in 1974. That experiment has "gone down in history as one of the biggest failures in public policy," Kochhar says, culminating after Nixon left office in the country's worst economic downturn since the Great Depression.

Stagflation Asia-style would erode the economic gains that the ADB estimates have lifted 300 million people out of poverty since 1990.

Though subsidies "may temporarily help alleviate symptoms of underlying inflationary pressures, they bypass the fundamental supply and demand balance and thus can ultimately be more costly," the ADB said. "Increased food and energy subsidies erode fiscal ability to provide social protection and support for a slowing economy and reduce funds available for development."

Expanding Economy

Inflation will exceed growth rates in Indonesia, the Philippines, Thailand, Vietnam and Singapore. A forecast last week by UBS AG projects that India's economy will expand 7.1 per cent in the year ending March 2009, down from 9.1 per cent in fiscal 2008 and slower than the projected 8.7 per cent inflation rate.

Goldman Sachs Group Inc has cut its growth forecast for Asia, saying exports are weakening and faster inflation is forcing central banks to raise borrowing costs. Asia excluding Japan will grow 8 per cent in 2008, slower than the 8.2 per cent predicted previously and weaker than the region's 9.4 per cent expansion last year, the report said.

Indonesia's growth, 6.3 per cent last year, is "insufficient" to reduce poverty and create jobs, the Paris- based Organisation for Economic Cooperation and Development said in a report last week that recommended reducing subsidies for fuel and electricity to create a better investment climate.

Higher deficits, rising prices and slower growth also would leave governments less to spend on needed improvements such as roads and utilities.

Pillar of Growth

At stake is one of the pillars of the Asian economic miracle of the last decade. Below-market fuel and power costs made it cheaper for manufacturers in export-dependent economies to operate, giving them a competitive advantage over rivals in other markets. Subsidised prices also left consumers with more disposable income, boosting demand for goods and services.

Now, higher costs will erode the export edge. That may lead to more shuttered factories in countries such as China that already have more manufacturing capacity than they need to meet domestic and foreign demand, putting millions of people out of work.

Hong Kong companies may close 20,000 plants in the neighboring Chinese province of Guangdong this year as higher wages and fuel prices raise costs, the Hong Kong Small and Medium Enterprises Association said last month.

More unemployment and less disposable income also imperil the domestic consumption that China and other nations have been trying to foster to reduce their dependence on foreign markets.

Missed Opportunity

"Governments have missed the opportunity in the good times to change the subsidies and now are facing greater challenges in political, social and fiscal terms," former International Monetary Fund Managing Director Rodrigo de Rato said in a June 24 speech in Singapore.

Handouts that began as long ago as the end of World War II have held down the prices Asian consumers pay for essentials from cooking gas to motor fuels. For example, official Chinese gasoline prices are about 23.50 yuan (US$3.44) a gallon, about 18 per cent less than in the US.

Subsidised gasoline costs the equivalent of US$3.15 a gallon in Malaysia, even after Prime Minister Datuk Seri Abdullah Ahmad Badawi's government raised prices by 41 per cent in June. That is enticing motorists from neighboring Thailand, where gas is US$3.91, and Singapore, where it's US$5.95, to cross the border to fill their tanks.

Unaffordable Subsidies

Now, with the price of crude oil up more than 60 per cent in the last 12 months, governments are finding they can no longer afford to keep subsidies at historic levels, nor can they risk the shock of abolishing them. So other countries including China, Indonesia, Sri Lanka and India are also starting to make consumers pay more for fuel to limit the impact of subsidies on their budgets.

Even after India raised fuel prices, Prime Minister Manmohan Singh's government will still pay about US$42.5 billion in oil subsidies this year, more than twice as much as last year, and about six times the entire education budget.

That's robbing India of funds it needs for power and other infrastructure improvements to correct deficiencies that shave 2 percentage points from annual economic growth, the Finance Ministry estimates.

Malaysia, which spent US$10.8 billion on fuel subsidies last year, has shelved US$1.1 billion in public-works projects on railroads and highways. - Bloomberg