20000306

Inflation targeting tricky for Asia: analysts

SINGAPORE: Inflation targeting would bring a welcome predictability to policymaking in Asia, but analysts say the path to monetary nirvana is fraught with pitfalls.

The IMF has recommended Asia consider inflation targeting -- basing monetary policy on achieving a set level of inflation -- while price pressures remain subdued.

This can be done by targeting money supply, setting an actual inflation objective or managing the exchange rate.

The IMF noted that by adopting this policy, countries like New Zealand had benefitted from more accountable, independent central banks and greater transparency in policy-setting.

But these goals remain major hurdles in Asia, where many central banks are still subject to considerable political and private sector pressures.

There are also the obstacles of under-developed debt markets, establishing a credible target amid often volatile price pressures and the need for exchange rate flexibility.

"You've got to ask whether you're prepared to have your currency fully determined by the market. Are your institutions well built so that if people arbitrage you'll be able to mediate," said Fong Cheng Hong, head of market research at DBS Bank in Singapore.

"I don't think we're there yet. We don't even have a government bond market, how are you going to act like the Fed... You need the whole mechanism to be able to send the message, you need a deep enough capital market," she added.

JAPAN TALKS, THAILAND ACTS

The debate over inflation targeting rages on in Japan though the central bank, which has pursued a zero interest rate policy for over a year, is resisting pressure from some quarters to adopt a policy of intentionally inducing inflation.

In Thailand, the cabinet has approved changes to a central bank law, setting new guidelines for managing foreign reserves and a shift to inflation targeting from interest rate targeting.

But the Bank of Thailand still faces major challenges in establishing a credible inflation target in the face of potential political interference and volatile food prices.

A target that takes into account the inflation rates of Thailand's trading partners would help reduce exchange rate volatility, but the baht would still be vulnerable to instability caused by short-term capital flows, a Merrill Lynch report said.

"It is for this reason that high-level BOT officials argue that they will allow the exchange rate to be determined by the market mechanism only as long as there are no speculative elements in the market," Merrill said.

CENTRAL BANKS HAVE TO CHOOSE

This highlights the dilemma Asian central banks will face as they try to rein in inflation while at the same time keeping a grip on their exchange rates.

"If you're going to use interest rates as an inflation target and you have a relatively open capital account, which most Asian countries do, then you can't have an exchange rate target " said Don Hanna, head of Asian economic and market analysis at Salomon Smith Barney in Hong Kong.

It's less of a problem while there is slack in the economy and a currency is undervalued as exports are more resilient to exchange rate appreciation.

Although most Asian currencies are still well off their pre-crisis peaks, central banks tend to fret at any sign of sustained currency appreciation, which they see as threatening their jealously guarded export recoveries.

Korea is perhaps the clearest example of this quandary: the central bank has pledged to cap this year's inflation rate below 3.5 percent, but it is not keen to tighten rates aggressively given the fragility of financial markets.

And finance ministry officials are engaged in an almost constant battle with the market, intervening directly and verbally, as the won heads higher.

"Official policy towards the won appears unclear. A strong currency is the best tool to dampen imported prices, and the clear need is for a stronger won versus the dollar," Barclays Capital said in a recent report.

ASIA NEEDS ITS OWN RECIPE

Given Asia's current mix of rising inflation, a heavy reliance on export growth, large fiscal deficits and undeveloped interest rate markets, analysts say inflation targeting would not be appropriate in its pure form.

"Some inflation targeting is possible, but it cannot be dictated by monetary policy because of the nature of these economies," said Abhijit Chakrabortti, regional strategist at HSBC in Hong Kong.

"You've always got to make sure that fiscal policy is also moving in line with the requirements for inflation so it's got to be the appropriate policy mix rather than just the appropriate monetary policy," he said.

Asian governments should be tightening fiscal policy now as their economies return to trend growth, while striking a balance between stability, inflation targeting and growth, he added.-Reuters