Asian central banks are facing their moment of truth. For the last year, they have portrayed rising food prices as a temporary and largely containable challenge that is bound to pass without stirring a true inflationary spiral. To be sure, they have raised interest rates, albeit to a moderate extent. And they have relied upon less conventional methods, such as price controls and bank reserve requirements, to keep a lid on things. On Thursday, the central bank of China raised its reserve requirement by 50 basis points to a record 21 percent. It was the fifth increase this year and the eighth since October, according to Reuters.

“Central banks in Asia are at in inflection point,” says Jon Ruff, director of research for real asset strategies at AllianceBernstein. “The problem is there is risk on either side. If the banks have not done enough, they already are behind the curve. And depending upon how the economy decelerates, there is a risk that the have already done too much. It is something we are watching,” Ruff says.
A soft landing is largely in sight, at least for most of the region, says Phil Langham, senior portfolio manager and head of the emerging markets team at RBC Global Asset Management in London.
“Inflation is a problem, but it is likely to peak over the coming two or three months. It should improve during the second half of the year because food prices have stopped going up so fast and we are seeing some monetary tightening that will cause growth to slow in certain places like China,” he says.
The risk is that so-called secondary inflation effects already have taken root in the economy, according to Ruff. In emerging markets, relatively poor populations devote more than 50 percent of income to food, and they are particularly sensitive to an increases in those costs. To maintain social peace — and political power — governments have mitigated those rising costs by boosting wages as much as 20 percent in rural India and certain cities in China, according to Ruff. Those wages are expected to rise 20 percent this year, too. “That is a classic wage price spiral,” he says.
It’s not impossible that Asia’s central banks will be able to contain that spiral before it gets of control. But that may be a challenge.
“In most countries, inflation risks continue to be tilted to the upside--mainly because growth continues to be strong. More interesting, the nature of inflation is changing--a mix of demand pull and cost push. It is generally more imported in nature than before,” says Wai Ho Leong, Senior Regional Economist with Barclays Capital Singapore. China is starting to export inflation to other countries — a situation that the Bank of Korea has dubbed “Chinflation.”
How should investors protect themselves? Leong says China and India have been relatively aggressive about confronting inflation risks, but that Taiwan, Korea and Singapore are more plugged into global growth cycles and are most at risk from inflation. To protect against those conditions, he recommends inflation protected bonds and non-financial assets to boost yield.
China’s central bank, which has raised interest rates twice this year, has had some success in battling inflation and slowing growth, which dropped to 5.3 percent in April from 5.4 percent in March.
Deutsche Bank has lowered its growth forecast for China for this year to 8 percent from 9 percent.
The leveling off in the growth of food prices and the economy is encouraging, according to Ruff.
But to some extent, that decrease may reflect the fact that consumers are shifting their income to pay for higher energy costs, he says. The overall decline in inflationary pressures may not be as great as it seems.
Authorities in China and other emerging markets want to dampen inflation and growth without inflaming an often poor and price sensitive population. After all, rising food prices led to protests in Egypt and other countries in the Middle East and North Africa. That lesson can’t be lost on authorities in China, where the per capita income remains low despite the overall size of the economy. That means emerging markets such as China and South Korea in Asia and Uruguay and Brazil in Latin America are relying on capital controls such as reserves and price caps to limit growth without putting too much pressure on consumers.
Developed economies have a lot riding on the success of the inflation-fighting efforts in Asia. In the U.S., Fed chairman Ben Bernanke also has characterized food and energy price increases as a passing phase. The success of that effort in the U.S. will depend upon whether emerging markets in Asia and elsewhere overheat.