Steadily rising oil prices since 2001 continue to exert upward pressure on price levels worldwide. Despite tighter monetary policies in many countries of the region since 2005, there has been an increase in the Asian and Pacific region's average inflation rate, from 2.8 per cent in 2005 to 3.5 per cent in 2006.

Excluding developed economies, average inflation in Asia and the Pacific rose from 5.5 per cent in 2005 to 5.7 per cent in 2006. Compared with other regions in the world, Asia and the Pacific had slightly higher inflation than Europe (2.3 per cent) and North America (3.1 per cent), but lower than Latin America and the Caribbean (5.1 per cent) and Africa (8.2 per cent).

Figure 22.1 Inflation, by world region, 1995-2006

Inflation rates varied substantially, however, between countries and groups of countries. Economies with higher income levels were generally able to keep inflation rates at lower levels. Inflation among high-income economies have remained below 1 per cent throughout the last decade, despite an increase from 0.3 per cent in 2005. This is mainly due to the low inflation rate in Japan, which has been between -0.9 and 0.2 per cent since 2000. Low- and middle-income economies have had substantially higher inflation rates since 2000, ranging from 4.0 to 6.7 per cent and 6.3 to 10.4 per cent, respectively.

Figure 22.2 Inflation in selected Asian and Pacific country/area groupings, 2000-2006

The country groupings with the highest inflation rates in the Asian and Pacific region since 1995 were landlocked developing countries and Central Asian countries. Both groupings were equally affected by the Russian financial crisis in the early 1990s after the break-up of the Union of Soviet Socialist Republics. The two groupings overlap to a large extent - the Central Asian countries are almost all landlocked developing countries. Despite a decline from the record-high levels of the early 1990s, inflation rates remained high; in 2006, they neared 10 per cent, which is three times the average of the Asian and Pacific region.

For many countries in Asia and the Pacific, the fluctuations in inflation rates have been substantial since 1990. This is true in particular for the economies most affected by the Asian financial crisis in 1997-1998. Inflation in Indonesia, for example, was about 7.8 per cent in 1990, then peaked at nearly 58 per cent in 1998 but was below 7 per cent by 2004 (figure 22.3). Other examples of economies with large inflation rate variations include such oil-importing economies as Malaysia, Thailand, Nepal and Pakistan, where the steady increase in oil prices caused inflation rates to nearly double between 2004 and 2006.

Despite strong economic growth in China, inflation has remained generally well below 5 per cent since 1990 and below 2 per cent since 2005. The inflation rate in India, in contrast, continues to increase, from 3.8 per cent in 2004 to 4.2 per cent in 2005 and finally to 6.1 per cent in 2006.

Figure 22.3 Inflation in selected Asian countries, 2000-2006

Central banks today mostly use open-market interventions to influence money supply and thus inflation rates. However, a central bank's discount rates are often used as a signalling tool for capital markets to have an indication of the economic situation of a country, particularly in the case of the United States.

Interest rates

The upward pressure on price levels from steadily rising oil prices alone does not require tighter monetary policies. However, in many economies in the Asian and Pacific region, inflation is not only of the supply-push type; it is also due to demand-pull factors. To prevent overheating of the economy, many central banks have halted the steady lowering of discount rates since 1998 and adopted tighter monetary policies in recent years.

During the period 1998-2006, following the Asian financial crisis, many economies in Asia and the Pacific lowered discount rates (figure 22.5). The Central Bank of the Philippines, for example, has reduced the discount rate from 12.4 per cent in 1998 to 7.9 per cent in 1999 and 5 per cent in 2006. Similarly, the Central Bank of Thailand reduced its discount rate from 12.5 per cent in 1998 to 5.5 per cent in 2001. The slight increase to 6.5 per cent in 2006 is consistent with the steady appreciation of the Thai baht against the United States dollar since 2000.

Figure 22.4 Average inflation in Asia and the Pacific, 2000-2006

These discount-rate policy decisions only concern the short-term rates at which the commercial banks are able to borrow from central banks. They influence money market rates, but their effect on capital markets with longer maturities is much less clear, as capital market rates also depend on credit ratings, maturity and exchange rates. In general, the interest rates on 10-year government bonds vary less than the short-term central bank discount rates or Treasury bill rates (Treasury bill rates generally follow the pattern of a central bank's discount rates).

Figure 22.5 Central bank discount rate of selected countries, 1990-2006

In the case of the Philippines, for example, the 10-year government bond yield declined more strongly than the discount rate - from 18 per cent in 1998 to 7.4 per cent in 2006, thus making it less costly for the Government to borrow in the short term as well as the long term (IMF, 2007). The Government of Thailand also borrows on "cheaper" interest-rate terms-10.4 per cent in 1998 and 5.5 per cent in 2006. However, in the case of Pakistan, despite a decrease in the Central Bank's discount rate from 16.5 per cent in 1998 to 9.5 per cent in 2006, the 10-year government bond yield only decreased from 13 per cent in 1997 to 8.5 per cent in 2006. This suggests that, for economies particularly hit by the Asian financial crisis, the term structure turned from downward-sloping in 1998 to almost flat in 2006, making short-term borrowing as "expensive" as long-term borrowing.

For major economies in the Asian and Pacific region, however, bank policy rates have been rising in recent years and they may continue to do so, as monetary policy may further tighten, initially in the United States, followed by Japan, China and the euro area. Higher interest rates in developed economies are likely to affect financing conditions for developing economies by increasing their future borrowing costs. For countries with large debt-to-GDP ratios, and particularly those with relatively large short-term debt positions, such as Papua New Guinea, Indonesia, Turkey, the Philippines and Pakistan, rising interest rates could pose threats to economic expansion.

As depicted in figure 22.7, the short-term United States interest rate has gradually increased in relation to both Japanese and Chinese short-term rates since 2002. Changes in interest rates are likely to translate into changes in exchange rates.

Figure 22.6 Central bank discount rate of selected countries, 1990-2006

Figure 22.7 Dollar-yen and dollar-yuan interest rate differentials, 1990-2006

Exchange rates

The Asian financial crisis of the late 1990s stimulated the debate on the right currency regime choices in Asia and the Pacific. While IMF has been advocating more flexible exchange rate regimes in general, others argue for more context-specific solutions, such as exchange rates with fixed pegs to either a basket of foreign currencies or a single "hard" currency such as the euro, the Japanese yen or the United States dollar as a transitory regime for economies with emerging financial markets - China and the Philippines, among others. The regimes in between these two extremes are frequently deemed not to be sufficiently credible and thus prone to speculative attacks, as was experienced during the 1997 crisis.

Figure 22.8 Central Bank discount rate of selected Asian and Pacific countries, 2006

Following the crisis, many developing economies in the Asian and Pacific region had to abandon their traditional United States dollar-peg system and allow their exchange rates to float. However, it is important to differentiate between currency regimes announced by the central banks and de facto regimes. Empirical evidence is needed to determine how much flexibility the central banks really allow for their currencies.

Figure 22.9 Appreciation and depreciation of national currencies against the United States dollar in selected Asian and Pacific countries, 2000-2006

In the case of China, for example, the People's Bank of China announced, in July 2005, a revaluation of its currency and a reform of its exchange rate regime after more than a decade of pegging the yuan to the United States dollar at an exchange rate of 8.28. The revaluation put the yuan at 8.11 against the United States dollar, an appreciation of 2.1 per cent. Under the reform, the People's Bank of China announced that the yuan would be pegged to a basket of foreign currencies and would trade within a narrow 0.3 per cent band against this basket of currencies. In 2006, the average exchange rate was 7.97 against the United States dollar. Still, China's major trading partners, notably the United States, complain that the yuan is kept below its "real" market value in order to maintain current account surpluses and the high momentum of the economy.

During the past five years, the majority of Asian currencies have appreciated against the United States dollar due to the current account deficit that the United States economy has been running since 1982 (figure 22.9). The proportion of currencies in the Asian and Pacific region that has appreciated against the United States dollar since 2000 is as high as 68 per cent, similar to Europe (88 per cent) and Africa (50 per cent) but substantially higher than Latin America and the Caribbean (9 per cent).

With the United States current account balance deteriorating further, by US$ 100 billion, to above 6 per cent of GDP in 2006, the United States dollar risks continuing to depreciate against other major currencies worldwide. As many Asian and Pacific exports go to the United States, the steady appreciation of the major Asian currencies remains a challenge if countries in the region wish to maintain the level of their exports to the United States market while addressing inflationary pressure. This is true in particular given the low proportion of Latin American currencies that have appreciated against the United States dollar since 2000.