Deflation rears its head in Asia

Alan Wheatley, Reuters, Tokyo

The spectre of deflation is haunting Asia, bringing the risk of further pain to a region struggling with one of the steepest economic downturns on record.

Economists said the unfolding shock to global demand, coupled with a flood of goods from low-cost China, was putting heavy downward pressure on prices and could pose serious policy challenges if the trend persisted.

"It could cause a lot of problems. You just need to look at Japan. It could cause banking systems to become more fragile, borrowers to suffer even more as their debts get larger and make life difficult for policy makers, too," said Rob Subbaraman of Lehman Bothers in Tokyo.

The danger of deflation has come into focus after China and Taiwan both suffered an outright year-on-year decline in consumer prices in September.

They joined Hong Kong, which has experienced 35 straight months of falling prices because of its fixed exchange rate, which forces domestic prices to decline to retain competitiveness.

Demand has taken such a hit, driving down the price of everything from oil to computer chips, that Subbaraman saw a risk of deflation spreading beyond Greater China.

In Singapore, for instance, year-on-year consumer price inflation slowed to 0.8 percent in the third quarter from 1.7 percent in the second and is officially forecast to fall to less than 0.5 percent this quarter. Wholesale prices in September fell 1.4 percent.

The slide in Asian inflation contrasts with a surge in prices during the last recession in 1997/98. That was because fixed exchange rates had collapsed during the 1997 financial crisis, sending currencies into an inflationary tailspin.

Another structural factor weighing on prices is the inexorable rise of China as the world's lowest-cost producer in most sectors, robbing its competitors of pricing power.

Andy Xie of Morgan Stanley in Hong Kong said deflationary pressure was particularly acute in manufacturing, where assembly companies that have set up shop in China are now pressing their suppliers to follow them.

"As layers of component manufacturers move to China, Chinese labor costs work through the whole value chain and can ultimately bring prices down by one third or more for a large number of products that are traded in the world today," Xie said in a recent report.

With rapid urbanization likely to keep a lid on China's labor costs, and the home market unable to absorb its growing output, Vincent Chan of UBS Warburg in Hong Kong said he expected China to continue to export deflation.

"China's exports have been holding down world inflationary pressure, and I think that's going to last a long period of time," he said.

Low, stable inflation is good for growth because it gives investors confidence to make long-term commitments.

But broad, sustained price falls are a curse: consumers are tempted to postpone purchases knowing prices will get cheaper; borrowers have to sell or earn more to repay their debts; and declining asset prices stifle loan growth and economic activity, locking the economy into a vicious cycle of debt deflation.