Inflation in Developing Asia: Demand-Pull or Cost-Push?

8/22/2019 Inflation in Developing Asia: Demand-Pull or Cost-Push?

1/46

Economics and REsEaRch dEpaRtmEnt

ifl develg a:

de-pull r c-pu?

Juthathip Jongwanich and Donghyun Park

September 2008

RD WoRking PaPER SERiES no. 121


2/46


3/46

ERD Wrin Paper N. 121

InflatIonIn DevelopIng asIa:DemanD-pullor Cost-push?

JuthathIp JongwanIChanD Donghyun park

September 2008

Juthathip Jongwanich is Economist and Donghyun Park is Senior Economis t in the Economics and Research

Department, Asian Development Bank. The authors thank Ifzal Ali and William E. James for helpful comments and

suggestions, and Nedelyn C. Magtibay-Ramos for providing technical and research support. This paper represents

the views of the authors and does not represent those of the Asian Development Bank, its Executive Directors, or

the countries they represent.


4/46

Asian Development Bank6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippines

www.adb.org/economics

2008 by Asian Development BankSeptember 2008

ISSN 1655-5252

The views expressed in this paper

are those o the author(s) and do notnecessarily reect the views or policies

o the Asian Development Bank.


5/46

FoREWoRD

The ERD Working Paper Series is a orum or ongoing and recently completedresearch and policy studies undertaken in the Asian Development Bank or onits behal. The Series is a quick-disseminating, inormal publication meant to

stimulate discussion and elicit eedback. Papers published under this Seriescould subsequently be revised or publication as articles in proessional journalsor chapters in books.


6/46


7/46

CoNtENts

Abstract vii

I. IntroductionI. Introduction 1

II. Ination in Developing Asia A irst ookII. Ination in Developing Asia A irst ook 2

III. The Model, Data, and Econometric ProcedureIII. The Model, Data, and Econometric Procedure 6

I. Sources o Ination ariance Decomposition AnalysisI. Sources o Ination ariance Decomposition Analysis 8

. Pass-through o il and ood Price Shocks to Asias Ination 1. Pass-through o il and ood Price Shocks to Asias Ination 11

A. Pass-through o il Price Shock to Domestic Prices 1A. Pass-through o il Price Shock to Domestic Prices 11 B. Pass-through o ood Price Shock to Domestic Prices 17

I. Conclusion and Policy Inerences 2I. Conclusion and Policy Inerences 24

Appendix Impulse Response unctions or Producer Prices, Consumer Prices,Appendix Impulse Response unctions or Producer Prices, Consumer Prices,and Real GDP in Nine Developing Asian Economies 26

Reerences Reerences 5


8/46


9/46

AbstRACt

This paper empirically examines the relative importance o dierent sources

o ination in developing Asia. In particular, it tests the widely held view thatthe regions current ination surge is primarily the result o external price shockssuch as oil and ood shocks. In addition, this paper also estimates the degree o

pass-through o external price shocks to domestic prices. ur central empiricalresult is that contrary to popular misconception, Asias ination is largely dueto excess aggregate demand and ination expectations rather than external priceshocks. This suggests monetary policy will remain a powerul tool in the fght

against ination in Asia. Another signifcant fnding is that the pass-through o

the external price shocks to domestic prices has been limited so ar. However,the removal o government subsidies is likely to lead to greater pass-throughin the uture. The resulting inationary pressures provide a urther rationale or

tightening monetary policy.


10/46


11/46

I. INtRoDuCtIoNRising ination has emerged as by ar the biggest macroeconomic challenge conronting

developing Asia in 2008 and will remain a challenge in the coming year. In act, ination asmeasured by consumer price indices (CPI) gathered momentum throughout 2007 and accelerated

sharply in the frst hal o 2008 throughout the region. Higher ination is engulfng virtually all odeveloping Asia, although the exact magnitude o the increase in ination diers across countriesand subregions. or the region as a whole, ination is projected to rise to 7.8% in 2008, up sharply

rom 4.% in 2007 and .% in 2006. The benign paradigm o strong growth and subdued inationseems to have been shattered.

The obvious question to ask is, What has changed? The equally obvious answer is the spike in

international commodity prices, particularly ood and oil prices. Indeed according to an increasingly

popular diagnosis or developing Asias new ination problem, the region is suering rom a bout ocost-push ination. The sheer speed o the recent rise in commodity prices and hence input costsgives a great deal o credibility to the cost-push diagnosis. I higher ood and oil prices are indeed

what underlie Asias ination, the scope or anti-inationary monetary tightening, which works by

dampening aggregate demand, would come at a steep cost in terms o oregone growth impacts.There is a very real risk that the cost-push diagnosis will inuence regional monetary authoritiesand become an excuse or inaction against ination.

The central objective o this paper is to examine the validity o the cost-push diagnosis oination through rigorous empirical analysis. The undamental question addressed here is whetherdeveloping Asias ination is really a case o cost-push ination about which monetary authorities

can do very little, or, are there other actors at play. The impressive economic growth in developing

Asia over the past decade and the growth acceleration rom 2005 to 2007 took place with lowination. This high growth with low ination allowed monetary policy to be accommodative and

may have lulled monetary authorities into complacency. Is it possible that developing Asias inationmay be o the demand-pull variety in which excess aggregate demand leads to rising prices? Theanswer to that question has enormous implications or monetary policy in the region.

The answer uncovered through rigorous econometric analysis is that developing Asias inationis largely homegrown and due to excess aggregate demand and inationary expectations. Surgingaggregate demand has generated relentless upward price pressures. Aggregate supply, or the economysproductive capacity, could not meet the incremental demand in many Asian countries. While external

ood and oil price shocks have contributed to inationary pressures, our empirical evidence frmlyrules out the widely held view that Asias rising ination is mostly due to exogenous external shocks

beyond the regions control. or the region as a whole, excess aggregate demand and inationaryexpectations jointly account or about 60% o CPI ination. ur evidence is consistent with the

stylized act o accelerating growth accommodated by easy monetary policy in the region in the pastyear and at present. In particular, the regions recent robust growth makes it entirely conceivablethat overheating o the economy due to unsustainable demand growth ueled by cheap credit and

expansionary monetary policies, coupled with exchange rate policy avoring undervaluation mayhave helped to bring about the current outbreak o high ination.


12/46

In addition to our central objective o determining the relative importance o demand-pull

versus cost-push ination, an additional objective o the paper is to evaluate the extent to whichthe oil and ood shocks have actually translated into domestic ination. While our evidence speaksout loudly and clearly against the popular belie that external shocks are solely to blame or the

regions current inationary woes, it also reveals that those shocks have played a supportive role.However, partly due to government subsidies and trade restrictions, the estimated pass-through oexternal shocks to domestic prices is still limited in most o developing Asia. There is, however, aclear regionwide trend toward the reduction o subsidies, largely due to the fscally unsustainable costs

o subsidies in light o high market prices. Such prospective reduction o subsidies will signifcantlyexacerbate ination in many Asian countries in the near uture. In addition, our fnding that thepass-through o external price shocks has been substantially greater or producer prices than consumerprices also implies greater pass-through to consumer prices in the coming months. Thereore, both

subsidy reduction and greater pass-through o producer costs to consumer prices imply that cost-push inationary pressures are set to intensiy throughout Asia in the near uture.

The policy implication that ows rom our key fndings is that monetary policy will remain

eective and relevant in fghting ination in developing Asia. Since our evidence indicates thatexcess aggregate demand and ination expectations explain a major part o the regions ination,raising policy interest rates and changing the stance o monetary policy toward tightening is

necessary in order to dampen demand and anchor inationary expectations. Although the globalood and oil shocks are exogenous external shocks largely beyond the regions control, decisively andpreemptively deusing the risk o deeply entrenched long-term ination is well within the control othe regions central banks. urthermore, monetary policy itsel is likely to have contributed to the

ormation o inationary pressures. More precisely, loose monetary policies throughout the region,evident in the negative real interest rates that have become evident since late 2007 in most othe nine developing Asian countries considered in this chapter, have stoked aggregate demand to

unsustainable levels.

The rest o this paper is organized as ollows. Section II briey discusses the movementso ination in developing Asia. The empirical methodology we use to estimate the sources o

ination and extent o pass-through are presented in Section III. This section also discusses thetransmission mechanism that transorms external shocks into domestic ination. Section I reportsand discusses the central empirical fndings o this chapter, which pertain to assessing the relativeimportance o external oil and ood price shocks in explaining Asias ination. Section reports

and discusses additional empirical results, which relate to the pass-through o global ood andoil prices to domestic prices. The fnal section highlights the papers key fndings along with thepolicy implications.

II. INFlAtIoN IN DEvEloPINg AsIA: A FIRst look

Producer and consumer price ination measures in developing Asia have increased noticeablysince early 2007. In iet Nam, the consumer price ination accelerated to almost 25% year-on-yearin early 2008 while in the Peoples Republic o China (PRC) the consumer price ination jumpedto almost 9% in the second quarter o 2008, rom less than 2% in 2006 (igure 1). In the frst

quarter o 2008, Indonesias ination surged to almost 7.6%. Producer prices have risen evenaster than consumer prices in almost all regional countries. This is especially true in Indonesia,where the producer price ination rose to 25% year-on-year in 2008Q1, compared to 10% in early

2 September 2008

InflatIonInDevelopIng aSIa: DemanD-pullor CoSt-puSh?

JuthathIpJongwanIChanD Donghyun park


13/46

2007. In Thailand and Singapore, producer price ination rose to 10%, rom only 2.5% and .4%,

respectively, during the same period.

fIgure 1ConsumeranD proDuCer prICes InflatIon, 20002008 (perCent)

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

Indonesia Malaysia Philippines

Indonesia Malaysia Philippines

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

20

15

10

5

0

-5

30

25

20

15

10

5

0

-5

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

Singapore Thailand

20

15

10

5

0

-5

-10

10

8

6

4

2

0

-2

Singapore Thailand Viet Nam PRC Korea India

30

25

20

15

10

5

0

-5 2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

-5

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

10

8

6

4

2

0

-2

-4

-6

PRC Korea India

Consumer price inflation

Producer price inflation

Source International inancial Statistics online database, downloaded June 2008.

The spike in Asias ination is almost perectly coincident with the spike in commodity prices.The Brent crude oil price registered a new record high o $140 per barrel in early 2008, up romless than $60 in early 2007. The run-up in oil prices has been driven mostly by the undamentalso demand and supply (ADB 2008b). Surging global demand and the inability o global supply

to keep pace has generated relentless upward price pressures. The resulting reduction o surpluscapacity, which can absorb and cushion shocks, has also led to greater price volatility by ampliyingthe eects o even the smallest demand and supply shocks. inancial speculation may exacerbatetemporary short-lived price spikes and thus contribute to increased volatility.

ood prices have increased sharply since 2007, particularly the prices o rice, palm oil, andwheat. They rose by 62%, 94%, and 107% in the frst quarter o 2008, compared to 9% or overall

ood prices. The price o maize, which is a close substitute or wheat, also increased by 0%,while prices o other edible oils (e.g., soybean oil and coconut oil) rose by almost 90%. While thecauses o the run-up in the price o staple oods are complex, there are our undamental drivers(ADB 2008b). Rapid economic growth in emerging economies, particularly the PRC and India, put

upward pressure on prices o a variety o ood commodities. Demand has simply outpaced supply.A sustained decline in the United States (US) dollar since 2004 has added to upward price pressureon dollar-denominated commoditiesparticularly on crude petroleumwhich has ueled a search

SeCtIon II

InflatIonIn DevelopIng aSIa: a fIrStlook

erD workIngpaper SerIeSno. 121


14/46

or hedges against a weak dollar. The combination o high oil prices and legislative mandates to

raise production o biouel substitutes or gasoline and diesel uel established a price link betweeneed stocks (such as corn and vegetable oils) and uel prices. inancial speculation arising romlow interest rates has also helped push up commodity prices.

fIgure 2fooDanD fuel prICes, 1995:m12008:m4 (2000=100)

Food Brent

1995M1

1996M1

1997M1

1998M1

1999M1

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

400

350

300

250

200

150

100

50

0

600

500

400

300

200

100

0

Palm oil Rice Wheat

1995M1

1996M1

1997M1

1998M1

1999M1

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

Source International inancial Statistics online database, downloaded June 2008.

ne actor that has limited the impacts o oil and ood price spikes to domestic ination inmany Asian countries is the appreciation o the nominal exchange rate, especially against the US

dollar. In the Philippines, the nominal eective exchange rate (NEER) appreciated by 25% during20052008M2, while in PRC, Malaysia, Singapore, and Thailand, the appreciation was around 10%during this period. In Republic o Korea, NEER appreciated sharply by % during 20052007M7beore depreciating by 8% in 2007M72008M2. iet Nam was an exception in the sense that its

NEER depreciated by almost 10% during 20052008M2.

fIgure 3nomInal effeCtIve exChange rates, 2000m12008m2

130

120

110

100

90

80

70 60

70

80

90

100

110

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

2000M1

2001M1

2002M1

2003M1

2004M1

2005M1

2006M1

2007M1

2008M1

PRC India Indonesia Korea Malaysia Philippines Singapore Thailand Viet Nam

Note An increase reects exchange rate appreciation.

Sources International inancial Statistics online database, downloaded June 2008 or PRC, Malaysia, Philippines, andSingapore; sta calculations or other countries.

September 2008




15/46

So ar, the oil and ood price shocks have not perceptibly harmed economic growth in developing

Asia. igure 4 shows that a rise in ination in Indonesia, Korea, Malaysia, and Thailand during20062008Q1 was accompanied by an increase in growth. The growth rate o these countries wasaround 57%, higher than the average growth rate during 20012005. The growth slightly declined

in India, Singapore, iet Nam, and Philippines by 12 percentage points but the growth rate wasstill higher than 6% in the frst three countries and around 5% or the Philippines. Compared toother emerging economies, e.g., atin America (.1%) and developing Europe (5.4%), the growthrate in developing Asia was still impressive. While the regions ination is expected to reach 7.8%

and 6.0% in 2008 and 2009, respectively, its growth rate will still be around 7.5% and 7.2% (ADB2008b).

fIgure 4InflatIonanD growthIn DevelopIng asIa, 20012008Q1

16

14

12

10

8

6

4

2

0

2006

2007Q1

2008Q1

2001

PRC

Korea

5

4

3

2

1

0

2001

2001

2001

2008Q1

2008Q1

2008Q12008Q1

2008Q1

2007Q1

2007Q1

2007Q1

2007Q1

2006

2006

2006

2006

2006

0 2 4 6 8 10 12 14 16 18 20

2001

2001

2001

2001

2001

2008Q1

2008Q12008Q1

2006

2006

2006

2007Q1

2007Q1

2007Q1

2007Q1

20 4 6 8 10 12 10 2 3 4 5 6 7

7

6

5

4

3

2

1

0

10

8

6

4

2

0

-2

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

9

8

7

6

5

4

3

2

1

0

India Indonesia

Malaysia Philippines

10 2 3 4 5 6 7 8 10 2 3 4 5 6 7 8 10 2 3 4 5 6 7 8 9

Singapore

6

5

4

3

2

1

0

20

16

12

8

4

0

-4

Thailand Viet Nam

-4 -2 0 2 4 6 8 10 120

1

-1

2

3

4

5

6

7

10 2 3 4 5 6 7 8

10 2 3 4 5 6 7 8 9

Note The X-axis is GDP growth and the Y-axis is consumer price ination.

Sources International inancial Statistics online database and CEIC Data Company, td. database, downloaded June2008.

SeCtIon II

InflatIonInDevelopIng aSIa: a fIrStlook



16/46

III. thE MoDEl, DAtA, AND ECoNoMEtRIC PRoCEDuRE

The empirical analysis o this section seeks to identiy the sources underlying developing Asiasination, in particular the relative importance o demand-pull actors versus cost-push actors. Anadditional objective is to empirically examine the extent to which the ood and oil price shocks have

been passed through to domestic prices. This section briey lays out the model used to carry outthe two analyses. ur sample consists o nine regional economies, namely, PRC, India, Indonesia,Korea, Malaysia, Philippines, Singapore, Thailand, and iet Nam. A vector autoregression (AR)

model is estimated and a recursive Cholesky orthogonalization is applied to identiy the primitiveshock in the AR. This approach is used to model the dynamic interrelationship between the pricevariables in the distribution chain. The ordering and choice o variables is motivated by the ideathat prices are revised at each o three dierent stages (i.e., imports, production, and consumption),

which together make up a stylized distribution chain o goods and services. The model controls orexternal shocks and demand pressure. The model applied here is based on McCarthy (1999), Bhundia(2002), and Duma (2008)1 but is extended to include ood prices.

In this model, ination at each stage, namely import, producer, and consumer prices, is

composed o seven components. The frst two components, oil ( oil) and ood (food) price ination,are the eect o international supply shocks to ination (reerred to here as cost-push ination).The third component, output gap (y), is to proxy demand shock, while the eect o exchange rate

shock (e) on ination is captured in the ourth component. The fth and sixth are the eects oshocks to ination at the previous stage o the chain and the eect o shocks at that stage o thedistribution chain. In the model, import price ination (im) aects consumer price ination (C)

C ) directly, and indirectly through its eects on producer/wholesale price ination (

p ). The

last component is the expected ination at each stage, which is based on inormation available atperiod t-1. The seven components can be written as ollows

oil t toil toil

food

t t

food

t

oil

t

food

t

E

E a

y

= +

= + +

=

1

1 1

( )

( )

EE y b b

e E e c c

t t t

oil

t

food

t

y

t t t t

oil

t

fo

( ) + + +

= + +

1 1 2

1 1 2

( ) ood ty

t

e

t

im

t t

im

t

oil

t

food

t

y

t

c

E d d d d

+ +

= + + + +

1 1 2 4

( ) ee tim

t

p

t t

p

t

oil

t

food

t

y

t

e

t

imE e e e e e

+

= + + + + + +

1 1 2 4 5( )

t

p

t

c

t t

c

t

oil

t

food

t

y

t

e

t

imE f f f f f f = + + + + + +1 1 2 4 5 6( )

tt

p

t

c+

1 McCarthy (1999) examines the pass-through o exchange rate and import prices to domestic producer and consumerMcCarthy (1999) examines the pass-through o exchange rate and import prices to domestic producer and consumerination across nine developed countries, namely, Belgium, rance, Germany, Japan, Netherlands, Sweden, Switzerland,

United Kingdom, and US during 1976Q11998Q4. Bhundia (2002) estimates the exchange rate pass-through in South

Arica during 1976Q22000Q while Duma (2006) examines the pass-through o oil price hike, import prices, andexchange rate in Sri anka during 200M12007M7.

September 2008




17/46

whereoil

t ,

food

t ,

y

t and

e

t

are the shocks corresponding to supply, demand, and exchange rate

shocks.im

t ,

p

t and

c

t are the shocks emerging rom import, producer, and consumer price ination,

and Eis the expectation.2

The transmission mechanism o the model in determining sources o ination and the pass-through is as ollows. Suppose there is an exogenous shock rom international oil prices. In themodel, international ood prices would immediately adjust (quarterly basis in this study). Changesin international oil and ood prices would aect aggregate demand, while the exchange rate would

respond to oil and ood price hikes as well as changes in aggregate demand. In other words, theexchange rate is adjusted as a result o changes in the balance o payment position. Changes ininternational oil and ood prices, together with changes in the exchange rate, then immediately

aect import prices. This would result in an immediate impact on producer and consumer priceination, in addition to eects o aggregate demand. Import prices aect consumer prices in twoways, directly since some imported products are consumed directly, and indirectly through producerprices. In the next period, changes in consumer prices would eed back to aggregate demand, the

exchange rate, import demand, and producer prices through their eect on expected ination. Thisprocess also describes a ood price shock, except that changes in international ood prices wouldaect international oil prices in uture periods. Note that in this model, the degree o endogeneityincreases as the order is moved down. This may create the drawback o the recursive structure

because prices can eed back to aggregate demand within a period o one quarter, the requency othe data set. Thus, alternative orderings o variables should be estimated to check or robustnesso the results.

The model is estimated or the period 1996Q12008Q1. In the PRC and iet Nam, the estimationperiod is during 1999Q12008Q1 because o a lack o quarterly producer price index (PPI) andquarterly gross domestic product (GDP), respectively. or Indonesia and Malaysia, because o a lack

o inormation on import prices, the estimation covers the period 2000Q12008Q1. Dubai; spot UK

Brent; and the average o UK Brent, Dubai, and West Texas Intermediate are used to proxy raw oildata. Three ood prices, namely wheat, rice, and palm oil, are covered in this study. Wheat price inthe US Gul Coast and rice price in Bangkok are used to proxy international wheat and rice prices,

respectively. The palm oil price quoted in Malaysia is used to proxy international palm oil prices.The bilateral and NEER (trade-weight) are applied in the model to check the sensitivity o theresults. The measure o import prices (measured in domestic currency) is varied among countries.

In Thailand, the unit value o imports is applied, while in Korea and Singapore, the actual data oimport prices are used. In India, Indonesia, and Malaysia, a deator derived rom imports o goodsand services in quarterly GDP is used. It is important to note that import prices are excluded romthe PRCs and iet Nams estimation while producer prices are also excluded rom the latter because

o data limitation. The exclusion o these variables may lead to the underestimation o the pass-through o external shocks into ination in these countries.

In this study, aggregate demand is proxied by output gap, which is the gap between actual

and potential output (the level o output consistent with nonaccelerating ination). The actual2 In act, the ormation o inationary expectations could have both backward-looking and orward-looking componentsIn act, the ormation o inationary expectations could have both backward-looking and orward-looking components

(Mankiw et al. 200 and Ball 2000). However, previous studies such as McCarthy (1999), Bhundia (2002), and Duma

(2008) ound that backward-looking expectations better explain domestic prices in developing Asia. In addition, we

need to recognize that in developing Asia, there is a lack o reliable orward-looking indicators as those in industrialcountries with well-developed fnancial systems.

SeCtIon III

themoDel, Data, anD eConometrIC proCeDure



18/46

output is real GDP while the potential output is proxied by the trend o real GDP, derived rom

Hodrick-Prescott ilter. ther methods, such as exponential smoothing and Kalman flter, also providevirtually identical results, but the Hodrick-Prescott flter is selected here since it has perormedbest in terms o both explanatory and predictable power and diagnostic tests. Potential output is

an exogenous variable in the model. Thereore, changes in the output gap purely reect movementso aggregate demand. An increase in this variable thus implies an upward pressure o aggregatedemand. In particular, a value o the output gap that is greater than 1 reects excess aggregatedemand.

The oil, wheat, rice, palm oil, consumer and producer prices, bilateral exchange rate, and NEERo PRC, Malaysia, Philippines, and Singapore; the import prices o Korea, Singapore, and Thailand;and the industrial production index o the PRC are obtained rom the International Monetary unds

International inancial Statistics (IS). Gross domestic product is rom the CEIC Data Company,td. database, while NEER o India, Indonesia, Korea, Thailand, and iet Nam are obtained romcountry sources.

Based on the augmented Dickey-uller test, all variables were ound to be nonstationary I(1),

with an exception o output gap (y), which exhibits stationary I(0). No cointegration was oundbetween the variables with the output gap entering as stationary variable. Thus, the AR model

was estimated in frst dierences to avoid the spurious regression problem. The diagnostic tests,composed o AR root test (stability condition), auto correlation M test, normality test, and Whiteheteroskedasticity test are applied. A visual inspection o the residuals is also perormed to ensurethat there are no major outliners. The lag length is aided by using the lag length criteria provided

by Akaike and Schwarz Inormation criterionand diagnostic tests.

The relative importance o cost-push versus demand-pull actors in determining producer andconsumer price ination is explored through variance decomposition, which separates the variation

in endogenous variables (producer and consumer price ination) into the component shocks in theAR model. In order to measure pass-through coefcients, impulse response unctions are applied.

Impulse response unctions trace out the dynamic eects on prices originating rom a one-timeshock to the system, and accounts or disturbances o the other endogenous variables. Thus, thepass-through coefcients o oil (ood) prices are obtained by dividing the cumulative impulseresponses o each price index ater j months by the cumulative response o the oil price ater jmonths to the oil (ood) price shock.

Iv. souRCEs oF INFlAtIoN: vARIANCE DECoMPosItIoN ANAlysIs

In this section, domestic ination in nine developing Asian economies is decomposed intocost-push and demand-pull actors. Cost-push actors consist o international oil and ood priceswhile the main demand-pull actors are excess aggregate demand, proxied by the output gap, andinationary expectations, which are a unction o lagged domestic ination. Whether or not ination

is o the cost-push or demand-pull variety has vast implications or monetary policy. In the caseo cost-push ination, i.e., a situation where domestic ination is driven by rising input costs ogoods and services, a marked economic slowdown and rising unemployment is likely to accompany

higher domestic ination. Tightening monetary policy in the ace o such negative supply shockswould come at a steep cost. This is because tightening reduces aggregate demand, and exacerbateseconomic slowdown. Thereore, the cure could be worse than the disease. In contrast, i ination is

September 2008




19/46

SeCtIon Iv

SourCeSof InflatIon: varIanCe DeCompoSItIon analySIS

driven by an increase in aggregate demand beyond production capacity (i.e., demand-pull ination),

tightening monetary policy would be more eective. Tightening would reduce aggregate demandand thus dampen increases in the prices o goods and services, especially nontraded goods.

However, when inationary expectations are taken into account, monetary policy could play

an important role in containing inationary pressure, regardless o the source o the inationaryshock. There is always a risk that inationary expectations could get entrenched and lead to acost-price spiral. The stagation experience o industrialized countries in the 1970s, kicked o by a

supply-side shockthe 1971974 oil shockshows that this is not idle speculation but a very realrisk. These observations imply that monetary policy could play a major role in curbing inationarypressure, even in the ace o a negative supply shock. In short, decomposition o domestic inationinto its sources, including inationary expectations, would help monetary authorities to identiy

appropriate monetary policy responses. The eectiveness o monetary policy would be more limitedi the sources o ination are mainly external cost-push actors rather than demand-pull actors.But even then monetary policy would not be completely impotent since cost-push actors can also

cause ination expectations.

The results o the model estimation show that two actors unrelated to external price shocks,namely excess aggregate demand and inationary expectations (represented by the appropriately

lagged dependent variableconsumer price ination), can account or much o the consumer priceination in the nine countries. More than 60% o consumer price ination variation in the PRCresults rom demand pressure, and 4% and 21% in iet Nam and Singapore. Inationary expectationsexplain more than 45% o consumer price variations in the latter two countries. or the other

countries, excess aggregate demand accounts or less than 17% o consumer price ination, butinationary expectations account or almost 4050%. The two nonexternal actors can thus jointlyexplain about 60% o consumer price ination in the region as a whole.

External cost-push actors appear to be more important in explaining producer price inationthan consumer price ination (igure 5). These actors account or about 50% o the variation in

producer price ination in the PRC, Korea, Malaysia, and Singapore. In countries where exchange ratesare relatively stable (such as in Malaysia and Singapore), international oil prices account or aboutone hal o producer price ination. In Singapore, which has the highest oil dependency among thenine countries, oil prices explain 50%. In Indonesia, Philippines, and Thailand, the exchange rateexplains much o producer price ination. In Indonesia, the exchange rate accounts or almost 40%

o producer price ination, and 29% and 27% or Philippines and Thailand, respectively. In India,more than 50% o producer (wholesale) price ination is explained by the two nonexternal actors,in particular inationary expectations (using the appropriately lag o producer price ination), whileexternal shocks accounted or about 25%.

verall, international price shocks account or less than 0% o total variation in consumerprice ination. As was the case or producer prices, the international oil price is the main external

determinant o consumer price ination in PRC, Korea, Singapore, and Thailand. In the PRC, oil priceination explains 22% o consumer price ination. ood prices are also important in explainingconsumer price ination in these countries, especially Malaysia and Thailand. Movements in theinternational ood price index accounts or about 10% o CPI ination in both countries. In the

PRC and Singapore, ood price ination shocks explain about 56% o CPI ination.

Note that to capture the overall movements o ood prices, prices o rice, wheat, and palm oil are replaced by anNote that to capture the overall movements o ood prices, prices o rice, wheat, and palm oil are replaced by anoverall international ood price index provided by IS (downloaded June 2008).



20/46

fIgure 5varIanCe DeComposItIons

Oil Food Exchange rate Import pricesAggregate demand (output gap) PPI (expectation) CPI (expectation)

80

60

40

20

0

80

60

40

20

0

Producer price inflation (percent) Consumer price inflation (percent)

PRC India Indonesia Korea MalaysiaPhi lippinesSingapore Thai land

Oil Food Exchange rate Import pricesAggregate demand (output gap) PPI (expectation) CPI (expectation)

PRC Indonesia Korea Malaysia Philippines Singapore Thailand Viet Nam

PPI = producer price index, CPI = consumer price index.

Source Sta estimates.

The variance decomposition perormed has amply demonstrated the importance o actorsunrelated to the external price shocks, mainly excess aggregate demand and inationary expectations,

in explaining the recent surge o ination in developing Asia. The unsustainably high output growththat has taken place between 2005 and 2007 was in part ueled by an excessively expansionarymonetary policy in many developing Asian countries. igure 6 shows that the output gap hasexpanded since 2005 in many countries. In the PRC and India, the ratio o actual GDP to the trend

o GDP increased rom 0.98 in 2005 to almost 1.02 in 2008. The act that the ratio exceeded 1 inthe two countries since 2006 suggests that aggregate demand has exceeded the rate o utilizationo production capacity, which is consistent with nonaccelerating ination. Easy monetary policy

contributed to the ormation o higher inationary expectations. Demand pressure also built upin iet Nam in 20052007, and the ratio still exceeded 1 in 2008Q1. This suggests that demand

pressure was still responsible or inationary pressures in iet Nam. Aggregate demand pressurehas also built up in Indonesia, Korea, Malaysia, Philippines, and Singapore since late 2006. The

output gap ratio exceeded 1 in these fve countries in 2006. However, in Singapore, the rise in oiland ood prices caused a decline in aggregate demand in late 2007 and brought down the outputgap ratio toward 1. In contrast to other countries, Thailand did not experience any signifcantdemand pressures. This reects the slow recovery o private investment and the overhang o political

uncertainty. The ratio o actual GDP to the trend o GDP peaked in early 2005 above 1.1 but thenell back gradually to below 1 by the third quarter o 2006.

Expansionary monetary policies and sustained balance o payments surpluses leaked into domestic

liquidity in many Asian countries. This helped uel aggregate demand expansion and an increase inthe output gap ratio. igure 7 clearly shows that both nominal and real lending rates declined in

the nine countries during 20012006. Even though countries such as PRC, India, Korea, Singapore,Thailand, and iet Nam hiked their nominal interest rates since 2007 in response to internationaloil and ood price hikes, real interest rates still ell due to an even higher increase in ination.The real lending rate was negative in PRC, Singapore, Thailand, and iet Nam in 20072008Q1. Thisindicates that monetary policy responses have lagged behind price developments. Another sign o

loose monetary policy that helped stoke demand is the growth o the broad money supply (M2) in

10 September 2008




21/46

SeCtIon v

paSS-throughof oIlanD fooD prICeShoCkSto aSIaS InflatIon

the early part o this decade. In iet Nam, M2 grew by around 0% while in the PRC and India,M2 grew by more than 15%. The rise in oil and ood prices provoked some tightening o monetary

policy more recently. Money supply growth declined in 20072008Q1, resulting in a decline in theoutput gap ratio.

fIgure 6output gap, 20012008

1.03

1.02

1.01

1

0.99

0.98

0.97

0.96

1.03

1.02

1.01

1

0.99

0.98

0.97

0.96

1.04

1.02

1

0.98

0.96

0.94

0.92

2001Q1

2001Q3

2002Q1

2002Q3

2003Q1

2003Q3

2004Q1

2004Q3

2005Q1

2005Q3

2006Q1

2006Q3

2007Q1

2007Q3

2008Q1

2001Q1

2001Q3

2002Q1

2002Q3

2003Q1

2003Q3

2004Q1

2004Q3

2005Q1

2005Q3

2006Q1

2006Q3

2007Q1

2007Q3

2008Q1

2001Q1

2001Q3

2002Q1

2002Q3

2003Q1

2003Q3

2004Q1

2004Q3

2005Q1

2005Q3

2006Q1

2006Q3

2007Q1

2007Q3

2008Q1

PRC India Viet Nam Indonesia Korea Malaysia Philippines Singapore Thailand

Note utput gap is measured by the deviation o quarterly GDP rom its trend, which is derived rom Hodrick-Prescottilter.


v. PAss-thRough oF oIl AND FooD PRICE shoCks to AsIAs INFlAtIoN

The preceding section has shown that excess aggregate demand and inationary expectationswere the immediate catalysts or Asias ination. Nevertheless, the evidence also indicates thatexternal actors still account or a substantial part o the regions ination. In this context, an

important issue is the extent to which two major external cost-push shocksthe recent run-upin international oil and ood priceshave actually passed through to domestic prices. The higherthe pass-through, the greater will be the impact o the oil and ood shocks on ination in Asia.The results that emerge rom our empirical analysis o pass-through are reported and discussedbelow.

A. Pa-r oi Price sc Dmeic Price

There are three key transmission channels through which changes in oil prices would aectdomestic prices. The frst is costs o production, which would increase since oil is a vital inputor production o a wide range o goods and services. In particular, it is used or transportation

in businesses o all types. The second is energy prices, whereby higher oil prices also cause, to

varying degrees, increases in other energy prices, depending on the ability to substitute otherenergy sources or petroleum. Such price increases would result in higher production costs. Thethird is wages, where depending on the nature o the labor market, nominal wage may be adjusted

according to higher inationary expectations, adding pressure to production costs.4 ur empiricalanalysis yields three central results.4 Note that when nominal wages are inexible, most o the macroeconomic adjustments to an oil shock would take the

orm o higher unemployment rather than higher ination.

erD workIngpaper SerIeSno. 121 11


22/46

fIgure 7nomInalanD real InterestratesanD money supply growth, 20012008 (perCent)

1412

10

8

6

4

2

0

25

20

15

10

5

0

1210

8

6

4

2

0

Mar01

Jul01

Nov01

Mar02

Jul02

Nov02

Mar03

Jul03

Nov03

Mar04

Jul04

Nov04

Mar05

Jul05

Nov05

Mar06

Jul06

Nov06

Mar07

Jul07

Nov07

Mar08

Mar01

Jul01

Nov01

Mar02

Jul02

Nov02

Mar03

Jul03

Nov03

Mar04

Jul04

Nov04

Mar05

Jul05

Nov05

Mar06

Jul06

Nov06

Mar07

Jul07

Nov07

Mar08

Mar01

Jul01

Nov01

Mar02

Jul02

Nov02

Mar03

Jul03

Nov03

Mar04

Jul04

Nov04

Mar05

Jul05

Nov05

Mar06

Jul06

Nov06

Mar07

Jul07

Nov07

Mar08

Mar01

Jul01

Nov01

Mar02

Jul02

Nov02

Mar03

Jul03

Nov03

Mar04

Jul04

Nov04

Mar05

Jul05

Nov05

Mar06

Jul06

Nov06

Mar07

Jul07

Nov07

Mar08

Mar01

Jul01

Nov01

Mar02

Jul02

Nov02

Mar03

Jul03

Nov03

Mar04

Jul04

Nov04

Mar05

Jul05

Nov05

Mar06

Jul06

Nov06

Mar07

Jul07

Nov07

Mar08

Mar01

Jul01

Nov01

Mar02

Jul02

Nov02

Mar03

Jul03

Nov03

Mar04

Jul04

Nov04

Mar05

Jul05

Nov05

Mar06

Jul06

Nov06

Mar07

Jul07

Nov07

Mar08

PRC India Viet Nam Indonesia Malaysia Philippines Korea

15

10

5

0

-5

-10

-15

8

6

4

2

0

12

10

8

6

4

2

0

-2

-4

12

10

8

6

4

2

0

-2

-4

Malaysia Philippines KoreaPRC India Viet Nam Singapore ThailandIndonesia

(right axis)

50

40

30

20

10

0

25

20

15

10

5

0

30

25

20

15

10

5

0

25

20

15

10

5

0

-5

Indonesia Malaysia Philippines KoreaPRC India Viet Nam (right axis) Singapore Thailand

Singapore Thailand

Nominal interest rate

Real interest rate

M2 Growth

2000 01 02 03 04 05 06 0 7 08(June)

2000 01 02 03 04 05 06 07 08(June)

2000 01 02 03 04 05 06 07 08(June)

Note Nominal interest rate is lending rate while real interest rate is lending rate adjusted by consumer price ination.The direction o real policy rate and real lending rate is similar.

Source CEIC Data Company, td., downloaded 2 September 2008.

12 September 2008




23/46

SeCtIon v


irst, the pass-through o oil prices to producer prices tends to be higher in oil-exporting

rather than oil-importing countries, reecting the sharp increase in the opportunity cost o homeoil consumption relative to export. In Malaysia, the pass-through gradually increases rom 0.08% inthe frst quarter to reach a cumulative total o 0.15% in the ourth quarter. Cumulative pass-through

reers to the total pass-through ater a specifed time period. or example, i the pass-through aterone quarter is 0.0 and the pass-through during the second quarter is 0.08, then the cumulativepass-through ater two quarters is 0.05. In Indonesia and the PRC, which produce substantial amountso oil (Table 1), the cumulative pass-through increases to around 0.15% ater a year, in response

to a 1% increase in oil prices. or other oil-importing countries, the cumulative pass-through ooil prices to producer prices is around 0.07% ater a year. Singapore is an exceptional case in thesense that the high pass-through to producer prices is due to high intensity o oil use in totalenergy consumption. While the intensity o oil use in total energy consumption was almost 90%

in Singapore, it was less than 55% or all o the other countries (Table 1).

Second, the impact o crude oil price increases on domestic prices is diluted along thedistribution chain. The pass-through coefcients that measure the response to oil price shocks tend

to be lower or consumer prices than producer prices. The gap between these two price indices ineach country depends on the ability o frms to pass higher costs onto consumers. or example, inthe ace o intense market competition, private producers may cut their proft margins instead o

immediately charging higher prices to consumers. Government policy measures, i.e., uel subsidies,electricity subsidies, and other policies such as administered price policy designed to control livingcosts, reduce or delay the pass-through o oil price increases to consumer price ination. igure 8shows that the gap between pass-through to producer prices and pass-through to consumer prices

is rather narrow in the Philippines and Thailand, compared to the other countries.

Third, the degree o oil price pass-through to consumer prices is higher or countries withlimited uel subsidies. Within a group o our countries with comparable energy efciency levels,

pass-through to consumer prices is higher in the Philippines and Thailand (about 0.04% ater ayear) than in Malaysia and Indonesia (less than 0.02%). Although the level o energy efciency isrelatively low in the PRC, India, and iet Nam (total energy consumption to GDP in 2005 was 0%

in the PRC and around 20% in India and iet nam) uel price subsidies limit the impact o oil priceincreases on consumer prices. In the PRC, the pass-through to consumer prices is negative atertwo quarters, and turns slightly positive in the third and ourth quarters. This reveals that controlsand government intervention in decisions on pricing may have cushioned the consumers rom the

ull burden o rising uel costs. Similarly, in India and iet Nam, the pass-through coefcient isnegative in the frst quarters but turns slightly positive ater 1 year. Korea is an exceptional casein the sense that the low pass-through to consumer prices is due to superior energy efciency (i.e.,

total energy consumption to GDP in 2005 was 11%) rather than uel subsidies.



24/46

table 1oIl DepenDenCyanD energy effICIenCyfor seleCteD eConomIes,

1995, 2003, anD 2005

regIon/Country

oIlself-suffICIenCyIntensItyofoIluse(perCent) energyeffICIenCy

1 200 200 1 200 200 1 200 200

unied sae -0.6 -0.7 -0.8 7.8 9.5 40.1 12.4 9.0 8.1

Er Zne -0. -0. -0. . 1. 0. . .2 .

Japan -1.0 -1.0 -1.0 55.7 49.8 48.2 .9 5.2 5.0Ea Aia* ecdin

Japan -0.1 -0. -0. 2.0 2. 2. . 0. 2.

PRC -0.1 -0.4 -0.5 20.1 22.6 20.5 47.9 0.9 29.9

Hong Kong, China -1.0 -1.0 -1.0 62.7 61.4 60.2 4.4 6.0 5.8

Korea, Rep. o -1.0 -1.0 -1.0 66.0 51.6 48.6 12. 14. 11.7

Taipei,China -1.0 -1.0 -1.0 54.5 46.2 45.0 10.5 1.8 12.6

sea Aia* 0.0 -0.2 -0. . .0 . 1.1 20. 1.

Indonesia 0.9 0.0 -0.2 51.8 50.4 48.9 16.1 20.0 18.7

Malaysia 0.7 0.5 0. 56.4 9.9 9.7 16.5 2. 18.6

Philippines -1.0 -1.0 -0.9 72.1 54.4 52.5 1.0 15.8 1.5

Singapore -1.0 -1.0 -1.0 95. 88. 87.9 14.1 18.2 17.

Thailand -0.9 -0.8 -0.8 67.2 5.2 52.8 12.6 22.6 20.6

iet Nam 0.8 0.6 0.5 9.4 1.8 14.6 24.5 24.7 2.1

s Aia* -0. -0. -0. 0. . 1. 2. 22. 1.2

India -0.6 -0.7 -0.7 28.7 .7 0.8 2.1 2.7 20.1

Sri anka -1.0 -1.0 -1.0 68.9 81.9 82.6 11.2 11.0 9.0

Pacifc* 2. 0.2 2.1 .0 0. 1. 10. 1. 11.Cenra Aia* 0.0 1. 1. 2. 20. 1. 11. . .2

Wrd -0.1 -0.1 -0.1 .0 . . 12. 11. 10.

Note The oil sel-sufciency index is oil production less consumption, divided by consumption; a positive number indicatessome degree o sel-sufciency. I there is no domestic oil production, the index is equal to 1. Intensity o oil use

in energy consumption is petroleum consumption divided by total energy consumption. Energy intensity o GDP is

total energy consumption in (1,000) British thermal units per $1 o GDP (in 2000 prices).SourceInternational Energy Annual 2003 (Energy Inormation Administration 2005).

1 September 2008




25/46

SeCtIon v


fIgure 8CumulatIve CoeffICIentsof oIl prICe pass-through (perCent)

PPI CPI PPI CPI PPI CPI



0.25

0.20.15

0.1

0.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.25

0.20.15

0.1

0.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.25

0.2

0.150.1

0.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.25

0.2

0.15

0.10.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.25

0.2

0.150.1

0.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.25

0.2

0.15

0.10.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.25

0.20.15

0.1

0.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.25

0.2

0.150.1

0.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.25

0.2

0.15

0.10.05

0

-0.05

-0.1

-0.15

-0.2

-0.25

0.08

0.14 0.13

-0.010.002 0.01

-0.041

1 2 3 4 5 6 7 8 9 10

1 2 3 4 5 6 7 8 9 10

1 2 3 4 5 6 7 8 9 10

1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

1 2 3 4 5 6 7 8 9 101 2 3 4 5 6 7 8 9 10

PRC Indonesia

1 2 3 4 5 6 7 8 9 101 2 3 4 5 6 7 8 9 10

PhilippinesMalaysiaKorea

Thailand Viet NamSingapore

0.002 0.021

0.130.16

0.22

-0.03-0.01-0.02

0.04

0.01

0.07

0.03

-0.0040.015 0.024

0.06

0.02

0.07

0.040.04

0.06

0.02

0.04

0.13

0.01

0.16

0.040.014

0.02

0.16

0.03

0.07

0.008

0.07 0.08

0.003

0.15

0.023

0.14

0.0040.025

India

PPI = producer price index, CPI = consumer price index.Note The Y-axis reects pass-through coefcients, obtained by dividing the cumulative impulse responses o each price

index ater j months by the cumulative response o the oil price ater j months o the oil price shock. This couldbe interpreted as the percentage change in domestic prices (producer and consumer), resulting rom a percentage

change in oil prices. X-axis is the time period, which is on a quarterly basis in the study.




26/46

box 1growth ImpaCtof oIl prICe shoCk

High oil prices have adversely aected economic growth in Korea, Singapore, Philippines, andThailand, with pronounced impact in the two latter countries. In these two countries, a 1% rise in

oil prices is associated with 0.1% decline in real GDP in the frst quarter, compared to a negligibleeect in Singapore (igure 5). The pass-through o oil price shock in the Philippines and Thailandis complete ater 1 year, with the negative impact declining to 0.07% and 0.04%, respectively, in

response to a 1% increase in oil prices. In Singapore, the pass-through o oil price shocks to realGDP is relatively low and takes almost 2 years to complete. The negative impact, which appears in

the ourth quarter, is only around 0.01% and increases to 0.04% in the second year. In Korea, theeconomy adjusts quickly. The pass-through coefcient is 0.08 in the frst quarter, and becomes

negligible in the frst and second year. The relatively low negative impact o oil price increases onKorea and Singapore is due to high levels o oil and energy efciency (Table 1).

The economies o the PRC and India slow down somewhat in response to higher oil prices. InIndia, real GDP declines by almost 0.15% in response to a 1% increase in oil prices. Such negativepass-through eect is complete within 2 years, with a negative coefcient o 0.16. The negative

eects o oil price rises on the PRC are comparable to those in India in the second and third quarters.However, due to the lower level o oil sel-sufciency in both countries, the negative pass-through

eects tend to be diluted more quickly (Table 1).

As a net oil-exporting country, oil price increases appear to have an immediate and positive

impact on GDP growth in Malaysia. The pass-through coefcient to real GDP is 0.05 in the frst quarterand accelerates to 0.2 in the second quarter. The eects tend to be complete ater six quarters and

the pass-through coefcient is 0.18. In contrast to Malaysia, in iet Nam, the impact o oil price riseson GDP seems negligible. The relatively high level o energy dependency limits the positive impact

o oil price increase to GDP. Real GDP in Indonesia tends to increase only in the second quarter by0.0% but the pass-through becomes negative ater the third quarter onward due to high levels o oilimports. Indonesian oil sel-sufciency has declined signifcantly over the past decade, and since 2004

the country has become a net oil importer (in 2007, net oil imports accounted or 2.2% o GDP).

box fIgure 1CumulatIve ImpaCtsof oIl prICe shoCkto gDp

Oil_GDP

-0.25-0.2

-0.15-0.1

-0.050

0.050.1

0.150.2

0.25

1 2 3 4 5 6 7 8 9 10

PRC Indonesia

Malaysia Viet Nam

Oil_GDP

-0.25-0.2

-0.15-0.1

-0.050

0.050.1

0.150.2

0.25

1 2 3 4 5 6 7 8 9 10

India Korea PhilippinesSingapore Thailand

Note Since potential output measured as the trend o real GDP and is kept as anexogenous variable in the model, changes in the output reects changes

in aggregate demand (i.e., real GDP).Source Sta estimates.

1 September 2008




27/46

SeCtIon v


b. Pa-r Fd Price sc Dmeic Price

This subsection examines the impact o the global ood price shock on domestic prices in thenine Asian countries. ood is not a homogeneous product so we analyze three specifc ood productsthat are particularly important or the region, namely rice, wheat and palm oil. Three key results

emerge rom our empirical analysis.

irst, the pass-through to producer prices is higher in ood-exporting countries than in ood-importing countries. The higher pass-through will provide armers in those countries with incentives

to expand their production. This result is consistent with the fndings o the special chapter inAsianDevelopment Outlook Update 2008 (ADB 2008b), which fnds a substantial degree o transmissionrom world ood prices (rice in particular) to domestic ood prices. Among rice-exporting countries,

namely, Thailand (5% o global rice exports), India (17%), and PRC (%), producer prices increaseby a cumulative total o 0.020.06% ater 1 year in response to a 1% rise in the world rice price.In contrast, the pass-through coefcients are negative or Indonesia, Philippines, and Singapore.The pass-through o palm oil prices to producer prices is higher in Indonesia and Malaysia than in

the other countries. In Indonesia, producer prices rise by 0.08% in the frst quarter and rise by a

cumulative total o 0.2% ater 1 year. In Malaysia, producer prices rise by 0.02% in the frst quarterand a cumulative total o 0.04% ater 1 year. or the other countries, producer prices increase byless than 0.0% ater 1 year in response to a 1% rise in palm oil prices. The pass-through o wheat

prices in India, a net wheat exporter, is an exception. The pass-through is limited as a result ogovernment subsidies. Note that a slight decline o the pass-through to producer prices in manycountries results rom a supply response to ood price increases.

Second, palm oil pass-through coefcients tend to reect the low share o vegetable oils inthe consumption basket,5 and the pass-through coefcients to consumer prices or palm oil tendto be lower than or rice or wheat. The exceptions are the PRC and India, where wheat has a lower

pass-through. The average per capita consumption o palm oil and vegetable oils among the ninecountries was .2 kg and 9.5 kg, respectively, compared to 9 kg or wheat and 102 kg or rice

(Table 2). In iet Nam, or example, the cumulative pass-through o rice prices to consumer pricesis 0.08% ater 1 year, compared to 0.02% or wheat and 0.01% or palm oil. In Thailand, the

cumulative pass-through o palm oil, wheat, and rice prices to consumer prices ater 1 year are0.002%, 0.01%, and 0.07%, respectively.

Third, ood subsidies limit the degree o pass-through to consumer prices in many Asian

countries. While the per capita rice consumption o the Philippines and Indonesia is relatively highat 110 kg and 141 kg, respectively, which is comparable to PRC, Thailand, and iet Nam (Table 2),high subsidy levels limit the pass-through.6 The pass-through coefcient is also negative or very

low or Korea and Malaysia. This is a result o both a small share o rice in the consumption basketand some rice subsidies. or wheat, there is negative pass-through to wholesale prices in India anda very limited pass-through to consumer prices in Malaysia. Since the two countries are relatively

heavy wheat consumers (i.e., more than 60 kg/capita), it is likely that the limited pass-through islargely due to government policies that impede the adjustment o domestic prices to international

5 Note that the share o ood expenditure in the consumption basket in the CPI is a better indicator in explaining theNote that the share o ood expenditure in the consumption basket in the CPI is a better indicator in explaining thedegree o ood pass-through to domestic prices. However, with data limitations, this study uses consumption per capita

to proxy the importance o each ood product in the consumption basket.6 See Special Reportood Prices and Ination in Developing Asia Is Poverty Reduction Coming to an End? (ADBSee Special Reportood Prices and Ination in Developing Asia Is Poverty Reduction Coming to an End? (ADB

2008a).



28/46

wheat price rises. In Indonesia and Malaysia, government policies such as export taxes and price

controls on cooking oils limit the pass-through o palm oil prices to consumer prices. The percapita consumption o palm oil in these two countries was around 68 kg, which is higher thanthe average o .2 kg or the nine Asian countries.

fIgure 9CumulatIve CoeffICIentsof fooD prICe pass-through (perCent)

Prices_PRC

0.

05

0.

06

-0.

006

0.

03

0.

02

-0.

06

0.

03

-0.

02

-0.

03

-0.

02

-0.1

1

0.

01

0.

01

-0.

01

0.

00

0.

02

-0.

02

-0.15

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8

PPI (Rice) CPI (Rice) PPI (Wheat)CPI (Wheat) PPI (Palmoil) CPI (Palmoil)

Prices_India

0.

01 0

.02

0.

02

-0.

004

-0.

008

-0.

005

-0.

01

0.

004

0.

003

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8

WPI (Rice) WPI (Wheat) WPI (Palmoil)

Prices_Indonesia

-0.1

7

-0.1

7

-0.1

0

-0.

018

-0.

018

0.

005

0.1

0

0.

08

-0.

003

0.

026

0.

022

0.

011

0.1

60.

20

0.

08

-0.

02

-0.

02

-0.

05

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

1 2 3 4 5 6 7 8

Prices_Korea

0.

03

0.

03

0.

02

-0.

005

-0.

007

0.

003 0

.02

0.

02

-0.

003

0.

005

0.

006

-0.

01

0.

008

0.

008

0.

01

-0.

001

0.

00.

004

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8

Prices_Malaysia

0.

068

0.

071

0.

016

0.

002

0.

004

0.

003

0.

044

0.

05

0.

03

0.

007

0.

01

0.

04

0.

04

0.

018

-0.

01

-0.

01

-0.

01

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8

Prices_Philippines

-0.

07

-0.

20

-0.

21

-0.

046

-0.

042-

0.

003

0.

043

0.

038

0.

019

0.

012

0.

009

0.

003

-0.

09

-0.

08

-0.

03

-0.

02

-0.

01

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8

Prices_Singapore

-0.

07

-0.

06

-0.

048

-0.

041

-0.

09

0.0

1

0.0

1

-0.

01

-0.

01

-0.

02

-0.

02

0.

008

0.0

03

0.0

0

0.

00

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8

Prices_Thailand

-0.

01

-0.

01

0.

024

0

.019

0.

05 0

.07

0.

07

-0.

007

0.

015

0.

018

0.

01

3

0.0120

.03

0.

00.

00

2

0.0

1

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8

Prices_Viet Nam

0.

03

-0.

02

0.

03

0.

08

0.

010

.02

-0.

004

0.

01

-0.1

-0.05

0

0.05

0.1

0.15

1 2 3 4 5 6 7 8






WPI (Rice) WPI (Wheat) WPI (Palmoil)PPI (Rice) CPI (Rice) PPI (Wheat)CPI (Wheat) PPI (Palmoil) CPI (Palmoil)

Note X- and Y-axis are the same as igure 8.Source Sta estimates.

1 September 2008




29/46

table 2ConsumptIonper CapItaof key agrICulture proDuCtsfor seleCteD CountrIes, 19952003

wheat rICe palmoIl

1 2000 200 1 2000 200 1 2000 200PRC 79. 74.1 61.4 91. 87.6 78.5 1.1 1.0 1.5

India 6.6 57.2 6.6 80.7 74.7 71.1 0.8 .1 .4

Indonesia 21. 19.4 17. 146.5 148.9 141.1 7.1 7.7 7.9

Korea 48.7 52.9 48.4 95. 87.8 77.7 1.2 1.9 2.7

Malaysia 65.6 5.6 65.6 86.8 86.1 70.8 7.5 6.1 6.2

Philippines 1.5 27.0 29.7 94. 106.4 110.6 0.8 1.6 1.0

Singapore - - - - - - - - -

Thailand 9.2 10.5 11.5 105.6 106. 104.4 2.5 2.7 2.6

iet Nam 6.0 8.1 10.1 16.0 169.6 169.1 0.0 0.0 0.0

Asia 69.2 66.4 6.5 87.1 84. 79.4 1.7 2. 2.7

atin America 51.5 49.0 52.5 22.8 26.2 26.0 1.5 1.6 1.9Developing countries 62. 60.2 58.6 71.4 69.4 65.7 1.9 2. 2.7

World 71.0 68.4 67.0 57.6 56.8 54.2 1.6 2.0 2.2

- data not available.

Source ood and Agriculture rganization website (available http//aostat.ao.org/site/502/DesktopDeault.aspx?PageID=502).

SeCtIon v


http://faostat.fao.org/site/502/DesktopDefault.aspx?PageID=502http://faostat.fao.org/site/502/DesktopDefault.aspx?PageID=502http://faostat.fao.org/site/502/DesktopDefault.aspx?PageID=502http://faostat.fao.org/site/502/DesktopDefault.aspx?PageID=502


30/46

box 2growth ImpaCtof fooD prICe shoCk

Being rice exporters, PRC, India, Thailand, and iet Nam would experience increases in real GDPas a result o higher rice prices. In Thailand, a major global exporter, real GDP would increase by 0.24%

ater a year. A lower response o producer (wholesale) price in India and iet Nam would result in a lowerincrease in real GDP. In contrast, rice-importing countries suer negative eects on their real GDP. Thereal GDP o Malaysia, a major importer, would decline more than other countries to 0.1% ater a year,

compared to less than 0.07% in other countries. Interestingly, Korea experiences a positive impact onits real GDP. This is due to a very low level o net imports, with even net exports in some years.

As a net wheat exporter, India would experience increases in real GDP in response to higher wheatprices, and the coefcient tends to be higher than the coefcient or higher rice prices. Real GDP would

increase by 0.08% ater a year. The price o wheat is highly correlated with the price o other cereals,particularly maize.1 As a result, higher wheat prices also have a positive impact on the real GDP o some

maize-exporting countries such as the PRC and Thailand. In these two countries, real GDP graduallyincreases by almost 0.15% ater 1 year. In Indonesia, Malaysia, Philippines, and iet Nam, real GDPtends to decline in the frst and second quarters beore increasing slightly in response to producer price

increases. In Singapore, real GDP alls by 0.1% ater 1 year in response to higher wheat and maize prices.This is a larger negative impact than in any other country.

Being major global exporters o palm oil, Indonesia and Malaysia experience increases in real GDPas a result o higher prices. Real GDP tends to increase higher in Indonesia due to aster adjustment o

producer prices. Ater one year, real GDP in Indonesia rises by 0.05%, compared to 0.02% in Malaysia.Thailand, which is also a net exporter, sees its real GDP slightly increase in the frst and second quarter.

In India, due to relatively high consumption per capita o palm oil (.5 kg/capita) and vegetable oils(9.9 kg/capita), real GDP declines by almost 0.15% ater one year.2

continued.

1 During 1995M12008M4, the correlation coefcient between world wheat and maize was almost 0.9.2 Data on consumption (kilograms) o agriculture products per capita is not available or Singapore, but with Singapore

having no agriculture production base, the negative impact o agriculture price rises tends to be higher there than

in other countries.

20 September 2008




31/46

box fIgure 2

CumulatIve ImpaCtsof fooD prICe shoCkto gDp

Exchange rate_PRC

0.440.44

0.

31

0.

07

-0.

07

-0.1

0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6 7 8 9 10

PPI CPI

Exchange rate_India

0.140 0.137 0.137

0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6 7 8 9 10

PPI/WPI

Exchange rate_Indonesia

0.280.280.28

0.

09

0.

08

0.

08

0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6 7 8 9 10

PPI CPI

Exchange rate_Korea

0.

061

0.

068

0.

07

0.

071

0.

071

0.

05

0.00

0.10

0.20

0.30

0.40

0.50

1 2 3 4 5 6 7 8 9 10

PPI CPI

Exchange rate_Malaysia

0.

24

0.

25

0.

12

-0.

02

-0.

02

-0.

02

-0.1

0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6 7 8 9 10

PPI CPI

Exchange rate_Philippines

0.

35

0.

35

0.

26

0.

11

0.

11

0.

04

0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6 7 8 9 10

PPI CPI

Exchange rate_Singapore

-0.20 -0.20

0.005 0.0020.014

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

1 2 3 4 5 6 7 8 9 10

PPI CPI

Exchange rate_Thailand

0.

24

0.

29

0.

29

0.

06

0.

08

0.

09

0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6 7 8 9 10

PPI CPI

Exchange rate_Viet Nam

0.12

0.22

0.37

0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6 7 8 9 10

CPI

0.

14

Note Potential output, measured as the trend o real GDP, is kept as an exogenous variable in the model, hence changes

in the output reects changes in aggregate demand (real GDP).Source Sta estimates.

SeCtIon v


box 2. continued.



32/46

box 3pass-throughof exChange ratesto DomestIC prICes

Since the exchange rate has important implications or monetary policy, the degree o exchange

rate pass-through to domestic prices in nine developing Asian countries is examined here. In the AR

model, exchange rate shock is assumed to enter into the model as an exogenous variable in the frstperiod (when there is a depreciation o the US dollar) but in the ollowing periods, it is allowed tointeract with other variables endogenously. In other words, changes in domestic demand and domesticprices would inuence movements o the exchange rate in the ollowing periods.

The estimation result shows that the exchange rate pass-through1 is higher than the pass-through

o oil and ood shocks or both producer and consumer prices. This is probably because the exchangerate aects all import prices. As was the case or uel and ood prices, the pass-through to producerprices is higher than consumer prices. There are two key channels through which the exchange rate

aects producer and consumer prices. irst, the exchange rate aects the cost o imported inputs andfnished products and thus the overall price level o tradables. The second, indirect eect would occur

through changes in domestic demand or via changes in ination expectations o wage bargainers andprice setters.

The pass-through coefcients o producer prices are comparable in Indonesia, Malaysia, andThailand but the speed o the pass-through is aster in the ormer than the latter two countries (Box

igure ). A 1% depreciation o the exchange rate leads to a 0.12% increase in producer prices inMalaysia in the frst quarter, while producer prices rise by 0.24% and 0.28% in Thailand and Indonesia,

respectively. Ater 1 year, the exchange rate pass-through is around 0.250.0% in these three countries.However, in terms o consumer prices, the pass-through is comparable in Thailand and Indonesia (0.08%over a year), but turns out to be negative in Malaysia.

Korea and India show a low degree o exchange rate pass-through, but a aster speed o adjustment.or producer prices, the exchange rate pass-through is complete in the frst quarter, with coefcients o

0.07 in Korea and 0.14 in India. or consumer prices, the pass-through is complete ater three quarters,with coefcient o 0.07 in Korea. Singapore is an exceptional country with negative pass-through to

producer prices and a very low degree o pass-through to consumer prices.2

or the PRC, Philippines, and iet Nam, the pass-through coefcients o both producer and

consumer prices are higher than the above countries. Ater 1 year, producer prices increase by 0.44%and 0.6% in the PRC and Philippines, respectively. Consumer prices in the PRC increase by 0.07% ater

a year, and 0.22% in iet Nam. The pass-through to consumer prices is lower in Philippines than in theother two countries.

continued.

1 This result is based on the nominal eective exchange rate.2 The result is insensitive to exchange rate chosen (bilateral or nominal eective exchange rate).

22 September 2008




33/46

The results o this study are comparable to those o other studies. or example, Choudhri and Hakura

(2001) fnd the negative pass-through in Singapore (0.1 or 1 year) in response to a 1% depreciationo the exchange rate, and a very low pass-through in Malaysia (0.05). Hausman et al. (2000) ound a low

exchange rate pass-through in Singapore (0.02), Thailand (0.0), and India (0.07), but a relatively highpass-through in the PRC (0.), Indonesia (0.4), and Philippines (0.5).

box fIgure 3CumulatIve CoeffICIentsof exChange rate pass-through

GDP_PRC

0.

00

0.

13

0.

12

0.

13

0.

06

0.

15

0.

04

0.

05

-0.

04

-0.2

-0.1

0

0.1

0.2

0.3

1 2 3 4 5 6 7 8

GDP_India

0.

00 0

.02

0.

02

0.

10

0.

07

0.

08

0.

12

-0.

12

-0.

13

-0.

06

-0.20

-0.10

0.00

0.10

0.20

0.30

1 2 3 4 5 6 7 8

GDP_Indonesia

-0.

032

-0.

031

-0.

026

0.

07

0.

06

0.

00 0

.03

0.

05

-0.2

-0.1

0

0.1

0.2

0.3

1 2 3 4 5 6 7 8

GDP_Korea

0.27

0.

09

0.

12

0.

00

0.

06

0.

07

0.

10

-0.

01

0.

09

-0.2

-0.1

0

0.1

0.2

0.3

1 2 3 4 5 6 7 8

GDP_Malaysia

-0.

13

-0.

12

0.

00

-0.

05

0.

03

0.

04

0.

02

0.

02

-0.2

-0.1

0

0.1

0.2

0.3

1 2 3 4 5 6 7 8

GDP_Philippines

-0.

07

-0.

09

-0.

03

0.

06

0.

06

0.

00

-0.

01

-0.

005

0.

08

-0.2

-0.1

0

0.1

0.2

0.3

1 2 3 4 5 6 7 8

GDP_Singapore

-0.

05

-0.

10

-0.

06

-0.

01

-0.

15

-0.

11

-0.

13

-0.

09

-0.

04

-0.20

-0.10

0.00

0.10

0.20

0.30

1 2 3 4 5 6 7 8

GDP (Rice) GDP (Wheat) GDP (Palmoil)

GDP_Thailand

0.250.24

0.

00

0.

13

0.

12

0.

04

-0.

002

0.

00

0.

02

-0.2

-0.1

0

0.1

0.2

0.3

1 2 3 4 5 6 7 8

GDP_Viet Nam)

0.

037

0.

026

-0.

004

0.

005

-0.

002

-0.

01

0.

007

0.

001

-0.

004

-0.2

-0.1

0

0.1

0.2

0.3

1 2 3 4 5 6 7 8

GDP (Rice) GDP (Wheat) GDP (Palmoil) GDP (Rice) GDP (Wheat) GDP (Palmoil)

GDP (Rice) GDP (Wheat) GDP (Palmoil)GDP (Rice) GDP (Wheat) GDP (Palmoil)GDP (Rice) GDP (Wheat) GDP (Palmoil)

GDP (Rice) GDP (Wheat) GDP (Palmoil) GDP (Rice) GDP (Wheat) GDP (Palmoil) GDP (Rice) GDP (Wheat) GDP (Palmoil)

Note X- and Y-axis are the same as igure 8.


Choudhri and Hakura (2001) apply the frst dierence o log-linear relationship between consumer prices, lag consumerprice, nominal eective exchange rate, and oreign prices. Hausman et al. (2000) apply the error correction model to estimate

the same relationship as Choudhri and Hakura (2001) or selected developed and developing countries during 19901999.

SeCtIon v


box . continued.



34/46

vI. CoNClusIoN AND PolICy INFERENCEs

The central fnding emerging rom the empirical analysis o this paper is that developing Asiascurrent ination surge is largely due to two actors unrelated to the external oil and ood priceshocks, namely excess aggregate demand and inationary expectations. This fnding stands in sharp

contrast to the prevailing misconception that the regions rising ination is beyond the control omonetary policy, because it is mostly the result o the recent global ood and oil price shocks. Thepopularity o this view is partly due to the almost perect coincidence o the spike in commodity

prices and the spike in Asias ination. This provides regional policymakers with an excuse or notraising interest rates since monetary tightening tends to be much less eective against cost-pushination as opposed to demand-pull ination.

The specifc evidence that our analysis yields is that external ood and oil price shocks explainless than 0% o Asias CPI ination, while excess aggregate demand and inationary expectationsaccount or about 60%. At a minimum, such evidence implies that the regions current inationis not entirely due to outside orces beyond the regions control. In light o the stylized acts o

Asias recent macroeconomic perormance, i.e., years o uninterrupted rapid growth, it should come

as no surprise that excess aggregated demand plays a role in the regions soaring ination. Theimportance o overheating demand as a source o ination is especially evident in the PRC. Therecent evolution o the output gap indicates that excess aggregate demand has in act been growing

in many countries in the region. The inuential role played by inationary expectations in Asianination should also come as no surprise. Years o lax monetary policies by Asian central bankshelped stoke aggregate demand and ueled inationary pressures. The generally accommodative

stance o monetary policy has given rise to widespread expectations o higher prices.

ur econometric analysis o the pass-through o global ood and oil prices to domestic pricesindicate that subsidies have limited the extent o pass-through in many countries. Nevertheless,

there is a clear regionwide trend toward the reduction o subsidies, largely due to the fscallyunsustainable costs o subsidies in light o high international market prices. Those costs will

eventually orce those countries that still retain substantial subsidies to align their ood and uelprices more closely with international prices. Such prospective reduction o subsidies will signifcantly

exacerbate ination in many Asian countries. ur fnding that the pass-through o external priceshocks has been substantially greater or producer prices than consumer prices also implies greaterpass-through in the coming months. Producers tend to pass on higher input costs to consumers

only ater a time lag. Thereore, both subsidy reduction and greater pass-through o producer coststo consumer prices imply that cost-push inationary pressures are set to intensiy throughout Asiain the near uture.

ur central fnding, that excess aggregate demand and inationary expectations are at least asimportant as external shocks as sources o Asian ination, has vast implications or monetary policyin the region. In particular, it means that monetary tightening will continue to be a powerul tool

or fghting ination in Asia. Since domestic demand contributes substantially to aggregate demandand hence ination, especially in the PRC, higher interest rates and other monetary contractionmeasures can exert their usual anti-inationary eect by cooling down demand. Monetary policycan also have a more direct and immediate impact on inationary expectations, which are to alarge degree shaped by the basic stance o monetary policy. The prospects o greater cost-push

inationary pressures in the near uture urther strengthen the case or frmly anchoring inationaryexpectations through preemptive and decisive tightening o monetary policy.

2 September 2008




35/46

Eectiveness o monetary policy also depends on exchange rate policy. The movement o

exchange rate must be in line with tightening monetary policy, i.e., the exchange rate should beallowed to appreciate to reduce the domestic cost o imports. Intervention in oreign exchangemarket to keep the exchange rate undervalued would limit the eectiveness o tightening monetary

policy in anchoring ination expectations and clipping inationary pressures, especially in countrieswhere the pass-through o exchange rate movements to domestic prices is relatively high.

Monetary tightening, while urgently needed to contain ination beore it gets out o control,

is not without signifcant risks. In particular, the G slowdown will have adverse repercussions orthe export and growth perormance o developing Asia. Thereore, there is a downside risk thatmonetary policy may reinorce a contraction even ater demand had already begun to slacken.However, it is important not to exaggerate those risks. The more urgent priority or monetary

authorities right now is to contain inationary expectations rather than curb domestic demand.The regions growth prospects remain undamentally strong even ater ully actoring in the Gslowdown. Thereore, such risks do not diminish or compromise the broader policy message that

jumps out rom this paper, which is that there has to be a reshiting o the basic monetary policystance toward tightening throughout developing Asia. or ar too long, Asian monetary policy hasbeen lax and accommodative o excessive aggregate demand.

ne big reason or this is that since the end o the Asian crisis, priority has been to boosteconomic growth, all the more so since the region did not

Inflation in Developing Asia: Demand-Pull or Cost-Push?

Documents

Transcript of Inflation in Developing Asia: Demand-Pull or Cost-Push?