Excess liquidity in countries ranging from China to India to Saudi Arabia has pushed inflation rates higher all over the world. Yet when the developed countries’ credit crunch began in August last year, deflation looked a greater danger: the abundant savings in emerging markets offered hope that a deflationary spiral could be avoided.

As subprime mortgage losses mounted, contributing to wider losses from complex securities mainly held by US and European banks, the danger was that bank lending would start to shrink, threatening a vicious cycle of bankruptcies, further losses and further tightening of loan conditions. Injections of capital from Asian and Arab funds into western banks helped prevent such a cycle. Import demand and continued infrastructure investment in Asia and the Arab Gulf promised to help support global trade and, with it, wider economic activity.

The first part of this hope has come true: there is no sign of deflation in the US or western Europe, and the credit contraction has not become vicious. Measured by GDP growth rates, the second part also looks plausible: global growth has only slowed from more than 4.5 per cent in 2006-07 to about 4.3 per cent. That is far from disastrous. But what may prove disastrous are the inflationary consequences of this glut of Asian and Arab capital. Inflation has accelerated in the past year from 3 per cent to 7.7 per cent in China, 6.7 per cent to 11 per cent in India, 2.9 per cent to 10.5 per cent in Saudi Arabia, and from 3 per cent to over 5 per cent in Brazil. Low US interest rates are partly to blame: cuts by the Federal Reserve have been followed by central banks in many of these markets, or else such banks have left their interest rates unchanged when they should have been raising them to reduce money-supply growth.

That, though, is just a way of saying that in many countries — though not India — the problem has arisen due to currency policies. To control the exchange rate against the dollar, central banks have kept interest rates low and added to their foreign exchange reserves by buying dollars or euros, allowing some of the inflow to boost domestic money supply.

In all of those countries where rapid economic growth has coincided with a surge in inflation, the central bank needs to tighten monetary policy by raising interest rates. If it doesn’t, wages could start spiralling upwards, too, making inflation worse.

From a global point of view, one country’s central bank is more important than the others: China. The reason is two-fold. One is that China is the developing world’s biggest economy, the world’s fourth largest, and one of the most open to trade. So its economic performance affects others. The other reason, though, is that China’s liquidity and its rapid, resource-intensive growth in the past five years has been a big force behind the rise in price of oil and other commodities.

If Chinese demand continues to grow, then the oil price is likely to carry on rising, intensifying the inflationary pressure worldwide. But if the People’s Bank of China (PBOC), the country’s central bank, were to raise interest rates sharply (which are now well below the rate of inflation), bank lending growth would be cut and the economy would slow, cutting also China’s demand for oil. The only way to achieve this would be for the PBOC to allow the Renminbi to appreciate much more rapidly against the dollar and the euro, ceasing its purchases of foreign currencies.

The terrible earthquake in May in southern China has made the Chinese government hyper-sensitive to any criticism or threat of unrest. With the Beijing Olympics due in August, this is neither a time nor an atmosphere conducive to drastic monetary and currency measures.

For that reason, some analysts suspect the announcement in June of a slowing of the annual inflation rate from 8.5 per cent to 7.7 per cent may have reflected political manipulation of the data to buy time. If so, the pressure on oil prices and on global inflation may remain uncomfortably strong at least until after the Chinese summer, and the Olympics, have passed. In the autumn, however, the government’s nerve might well return. Inflation needs to be defeated.

The author is a former Editor of The Economist.
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(Businessworld Issue 1-7 July 2008)