Protecting against inflation

The FinanceAsia inflation index [for details see story published on our website on August 28] is intended to give a light-hearted look at the cost of a typical Hong Kong banker's basket of goods, from foie gras and cigars to an apartment in the Mid-Levels and a BMW. It was only ever meant as a bit of fun, but its results are no joke -- our index agrees with the official Hong Kong data on inflation: prices have fallen since last year.

In June, the city's consumer price index showed an overall 0.9% drop since the same month last year and, worldwide, fears of inflation have taken a backseat to the more immediate effects of the financial crisis.

Deutsche Bank predicts that prices in the US and Japan will fall during 2009, and stay flat in China. This seemingly benign inflationary environment is good news for households that have maintained their income levels, but it could be even better news for investors who want to protect their portfolios against rising prices.

The easiest way to hedge inflation in developed markets is to buy inflation-linked bonds, such as Tips in the US. Today, the 10-year Tips market is pricing breakeven inflation at 188bp, which means that buyers of these bonds will make money if inflation exceeds 1.88% during the next 10 years. That seems like a no-brainer. Needless to say, the crisis has created this opportunity.

Central banks are caught in a tough spot; policies aimed at staving off a deflationary depression through massive stimulus measures also risk causing an inflationary expansion of the monetary base once the recovery sets in. Optimists say that the excess cash can be mopped up before inflation takes hold, but there is a strong sentiment that inflationary pressure will be irresistible given the huge spending commitments in the US.

In this light, inflation of less than 2% seems like a pipe dream. History tells us that central
banks have been poor at controlling inflation after spending binges -- typically on wars. The
11-year moving average for inflation spiked to more than 5% in the US after the war of
independence, the civil war, both world wars and the Vietnam war. Today, with spot inflation in negative territory and the US in the middle of its biggest spending binge in history, there is a good opportunity to lock in an inflation hedge at a very favourable price.

"We are entering unchartered waters with all the liquidity injected by central banks," said Brice Benaben, head of inflation trading at Deutsche Bank in London. "There is a real concern that, with governments facing such huge debts, inflation is an easy way to reduce the level of the debt. Today, you would have a lot of trouble justifying that long-term inflation should be at the level we have experienced for the past 10 years."

Taking advantage of this view is easy enough in developed markets, but in Asia the only inflation-linked bond markets are in Japan and Korea and they are not very liquid.

Even in developed markets that lack a liquid supply of inflation-linked bonds, it is relatively
easy to use G3 inflation as a proxy hedge.

For example, Barclays Capital's Aussie dollar Inspire Index provides synthetic inflation protection for Australia by using a combination of liquid swap indices from the US, UK and Europe, but it is more difficult to rely on the correlation between developed and emerging markets.

"Proxy hedging may not work in China, or it will at least be very difficult to deliver it," said Amit Agarwal, director, rates structuring at Barclays Capital in Hong Kong. "The economies are very different. China's basket of consumption is very different; agriculture and food are the most important drivers of inflation, so it's very difficult to link to G4 inflation, where there is far more weight given to transport, housing, medicine and education. Central bank activity is very different between G4 countries and China, and also less coordinated. Further, currency management and price controls can affect inflation in China. So it's very difficult to say there should be a strong and stable correlation between G4 and emerging markets." 

This lack of an inflation market has left investors ill-equipped to hedge rising prices, not only in China but throughout the region. Indeed, the main drivers of inflation vary quite strongly from country to country. Food, for example, is 50% of the CPI basket in the Philippines, compared to 14% in South Korea.

The effects of fuel price rises are also greatly affected by wildly different subsidy policies in
the various Asian markets. As a result, the historical relationship between G3 and Asian CPI is inconsistent, but, according to data from Deutsche Bank, there is nevertheless a decent historical correlation in China, Hong Kong, Singapore, Thailand and Taiwan, which the bank says should allow investors in those countries to hedge about 40% to 50% of their inflation exposure by trading inflation products in the G3 markets -- typically an inflation-linked zero-coupon swap.

So far there are no easy hedges for country specific inflation, but for the past year Deutsche has offered an Asian inflation proxy index that takes the synthetic approach used by BarCap and adds commodities exposure to replicate the overall Asian economy. To work out the composition of the index, Deutsche looked at the IMF's inflation data for Asia and compared it to the G3 data. This led to a portfolio that comprises 70% European inflation, 50% US inflation and 30% Japanese inflation, plus 3% agriculture and 2% metals.

Clearly, this adds up to more than 100%. "While this might seem odd it is consistent with economic and practical theory; converging prices necessitate higher headline inflation rates in Asia," explained Deutsche in a report on its proxy index.

Using commodities as an inflation hedge is an old trick in Asia, but by themselves commodities are an inefficient solution for most portfolios -- whether as a hedge for an insurance or pension-fund portfolio, or for holders of nominal bonds. The seduction of commodities is that they do work in the long term; there is a positive correlation between commodities and Asian inflation.

But the problem is that in the short term the performance of commodities can wildly differ
from inflation. "Commodities as an underlying are so volatile," said Agarwal. "You don't know in a short period of time whether the product is led by commodity price supply-and-demand
fluctuations or the inflation in that particular country. At the end of the day, these products are a very weak hedge from a short-term perspective. I'm not really sure that we can use commodities to hedge inflation in the short term."

This still leaves Chinese inflation hedgers in a bind. They can buy G3 inflation and even proxy Asian inflation, which is heavily weighted to China, but there is still no perfect fit for local inflation -- and the same is true across the region. One solution is to source inherently inflation-linked assets from project companies such as toll roads, but this is an opportunistic and heavily tailored solution that is difficult to package in scale.

Part of the problem is that Asian governments have not traditionally worried about inflation. Until they do, it will be difficult for Asian asset managers and investors to create efficient hedges against rising prices. For bankers, that may mean they need to take it easy on the caviar and champagne.