Inflation targeting -- Good for emerging markets

May 23, 2007

Since 1990, when inflation targeting was introduced by Australia, emerging market economies have become better managed, according to a recent speech by IMF Deputy Director Murilo Portugal. Thanks to inflation targeting, emerging market countries were able to cut annual inflation rates from 10% in the ‘90’s to 4% since 2000. This led to slightly higher GDP growth, and a more stable economy for those countries. These observations were based on the performance of emerging markets that successfully adopted inflation targeting, including Mexico, Brazil, South Korea, South Africa and the Czech Republic.

What inflation targeting's effect means:
One of the most destructive forces in emerging market economies in the 1970’s and 1980’s was rampant inflation. Many countries’ central banks and governments allowed inflation because they didn’t want to sacrifice growth. However, the uncertainty from ever-increasing higher prices actually deterred financial investment, which ultimately led to slow growth, high debt, and finally debt defaults.

On the contrary, since 2000 many emerging market countries have paid off their IMF loans (See Indonesia repays IMF loan early, 10/25/06) This is a result of good economic policies, including higher liquidity, open capital markets and a free-floating exchange rate.

Therefore, the adoption of inflation targeting is yet again another reason why emerging markets have become less risky as an investment than in years past. The important key to success, as found by the IMF, is being flexible with the target. This means that central banks must allow inflation to hover within a range of the target, and not react too dramatically if inflation is a 1/4 or 1/2 point too high. (See Thai stocks plunge 15%, 12/27/06.)

Action steps:
Yes, emerging market funds - especially China - have become very highly priced, and are due for a correction. However, you need to keep them for your long-term funds to drive the growth you will need for a healthy retirement.

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