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With the threat of inflation looming large in Asia, companies would do well to act now to prepare for the challenges – and opportunities – that they could be presented with

This article was first published in the March 2012 International edition of Accounting and Business magazine.

No one imagines that Asians will be pushing wheelbarrows full of banknotes to the grocery store any time soon, but inflation is heating up enough for some finance experts to warn that companies should start taking it into account in their strategic planning.

Although the biggest emerging Asian economies may be somewhat protected by various kinds of capital restrictions (such as strict loan-to-value limits on mortgages in China), and generally strong sovereign cash positions, experts say that many Asian companies may still face some serious inflation risks in the near future.

So how do you prepare? While most Asian executives have dealt with rocky macroeconomic reversals at one time or another, most people familiar with the sustained inflation of the 1970s are now long retired. To try to figure out the best response, some economists and consultants are now dusting off 30-year-old playbooks to look for guidance. Here are their top recommendations:

1 Don’t wait until it hurts

As with most preventative measures, the time to prepare for inflation is before you think you’ll need it. ‘It’s a sweet poison,’ explains Ulrich Pidun, a principal in the Frankfurt office of The Boston Consulting Group (BCG) and co-author of two papers on inflation. ‘You don’t feel the threat because it feels so nice at the beginning.’

In an inflationary environment, the first symptom tends to be a strong growth in sales. If some of your costs, such as labour, aren’t climbing as quickly, this can seem like a real gain,’ says Pidun. Only later will your costs begin to creep up – and if they start to outstrip your ability to raise prices, your margins will suffer and you could find yourself in a serious bind.

Squeezed margins are already taking their toll in China, where thousands of factories shut in 2011. ‘A consolidation is taking place in the market, with better run and better capitalised players grabbing market share and becoming volume players,’ says Shaun Rein, managing director of the China Market Research Group and author of The End of Cheap China.

2 Keep costs down

Theoretically, it makes sense to take on more debt just before an inflationary period, on the expectation that those debts will be cheaper to pay off down the line. However, BCG research has found that companies that carried high leverage in the 1970s actually tended to suffer in the stock market.

Lack of cash can reduce flexibility at a time when you need it most, Pidun argues. ‘Your debt becomes cheaper in real terms, but the more important effect comes from whether or not you can afford to do your investments that are required. In this sense, having debt is negative because you may forego certain attractive investments just because you cannot pay for it, because asset prices inflate as well during inflation.’

BCG argues instead that the better policy is to try to cut costs as much as possible, giving the company more flexibility to handle inflationary pressures later on.

Certainly, companies look for possibilities in writing long-term contracts that reign in costs, finding instruments to hedge rising materials costs, and in looking for ways to hold down labour expenditures.

In China, rising wages are seen as a key component of inflation, rising so quickly that many companies are nearing a crisis point. ‘Wage inflation is a huge issue at the moment and actually it’s getting to the stage where unless it’s curtailed you could start to see companies struggle and even fall over,’ says Russell Brown, managing partner of LehmanBrown, an accounting and business advisory firm specialising in Chinese companies.

This is not only an issue in China. A recent survey by Vietnamese employment agency Navigos Search found that in 2011, more than 70% of managers and executives, and 68% of general staff, saw raises of at least 11%.

As a result, some Chinese companies are doing what developed countries did 10 years ago and outsourcing their work to China – western China, that is, where wages are lower and the government is offering tax incentives until 2020 to employers who open new factories and facilities.

In general, although the recent trend has been towards making more costs variable, in an inflationary environment, it is better to try to create more fixed costs, Pidun says.

Just how serious might those rises be? One key component to watch is where the dollar is trading. A study by Steve Hanke, a professor of applied microeconomics at Johns Hopkins University, found that 50% to 60% of the volatility in most commodities ties back to movements in the dollar. As most major commodities trade in dollar terms, any decline in the dollar will serve to drive up the price of the commodity.

But don’t expect Asia to try to diversify out of the dollar any time soon. Hanke says that reserve currencies typically last a very long time. ‘The average life of these things has been over 300 years each. It’s very hard to challenge a dominant world currency,’ he says.

3 Squeeze your working capital

If raw material prices rise consistently, companies may start to hoard to protect themselves from further increases. But more inventory in the warehouse translates into more money tied up in working capital – and that can make the company much less efficient. Shipping is also becoming an issue, says Hanke – not just because of fuel costs but because long sea voyages can expose cargo owners to shifts in cost and more expensive trade financing.

Growth in receivables may be even more dangerous. For example, if a company with US$1bn in sales grows by 5% a year, it will need US$50m more in working capital. However, if inflation is climbing at 10%, even if the economy is still moving, working capital is suddenly US$150m.

‘This can really pose a problem if you don’t have the cash to finance it. You may forego certain contracts or you may forego certain investments that you just cannot afford anymore,’ Pidun says.

4 Forget your instincts

Inflation creates an economic situation so different from the ordinary that it can be difficult even for professionals to come to terms with its full implications.

The most common mistake is to think in nominal values. For example, some researchers have theorised that although stocks are supposed to be a good hedge against inflation, they actually did not perform well because analysts made a mistake in how they evaluated cashflows, according to Hersh Shefrin, professor of finance at Santa Clara University’s Leavey School of Business.

‘They didn’t adjust future cashflows appropriately for inflation but they did adjust the discount rates for inflation,’ Shefrin says. ‘In a highly inflationary environment, what that does is it penalises future cashflows very heavily.’

Management experience may also introduce biases into your understanding. ‘People ignore historical evidence from either before they were born or before they were paying attention,’ Shefrin says. ‘People who were around during the 1970s will tend to forecast higher rates of inflation than people who came of age in the 1990s.’

This kind of systematic bias even holds true for professionals. All through the 1980s and 1990s, when inflation began to decline, economists kept missing the fact that inflation was slowing down.

‘Throughout the 80s and early 90s you could almost predict the size of the error in the announcement of the [Consumer Price Index] based on the inflationary forecasts done by professionals because they were consistently off by about the same bias,’ Shefrin says.

‘It’s not that people don’t learn, it’s just that they don’t learn quickly,’ says Shefrin. ‘They learn slowly and sometimes painfully.’

5 Set your pricing strategy

Most of all, you will need to reconsider your pricing strategy. The most defensive strategy of course – and the one most often recommended – is to try to keep pace with inflation, but this is not the only option.

In Europe and the US, some packaged food companies have maintained prices but reduced the amount of food in the package.
Other, more inventive solutions may also be possible. There may be an opportunity for a new business model that can give the buyer a greater perception of control, such as the Bristol-Siddeley aircraft engine ‘power-by-the-hour’ model, a 1965 innovation by the British engine company that leased running time rather than equipment itself, making it easier for the leasing company to forecast prices.

Inflation can even be an opportunity for a producer with a lower-cost structure, who may want to hold on tight and force the higher-priced competitors out of the market. But even if your company is not in a position to do this, it is something to be wary of, given the propensity of Chinese companies to wage high-stakes price wars when they see an opening.

Conclusion – stay alert

In the East, there is little room for error. Restructuring tends to be difficult to arrange outside the major cities, Brown says, and little financing is available to do this. ‘There’s a reasonable amount of capital sloshing around, in terms of venture capital and private equity firms, but there’s a limited amount of capital around for restructuring or transformations,’ he says.

Of course, economic forecasts are far from exact; as one old joke puts it, economists have predicted nine out of the last five recessions. Yet the difficulties with sovereign debt and government revenue shortfalls all over the world suggest that the odds are good that there’s inflation in your future.

However, if inflation does stop suddenly, it always ends in a recession, according to Pidun. At that point, the tactics need to change again. While free cash is still going to be welcome, companies typically need to hit the brakes.
‘Just as the beginning of an inflation is very favourable for consumption, the end of an inflation is very dangerous for it,’ Pidun says. Instead, think about reducing capacity, preserving cash and identifying distressed competitors you may be able to take over.

Bennett Voyles, journalist

When the music stops

Private equity firms are now spotting opportunities in the tighter credit conditions, says Henry Ong, a mergers and acquisitions (M&A) lawyer for Weil Gotshal & Manges in Hong Kong. With the slowdown in the initial public offerings (IPO) market, many young companies are feeling the pinch as impatient investors look to cash out – creating an opening for private equity.

Accountancy firms may be even luckier, with any change in the business climate a potential opportunity. Russell Brown, managing partner of LehmanBrown, plans to open three new offices in western China over the next three years, as more coastal firms move inland in search of lower wages. He is also looking to expand the firm’s expertise in turnaround management.

As for wage inflation, bad news for the profit and loss account is good news for the personal balance sheet, particularly for executives. A survey by global executive search firm Russell Reynolds Associates found that compensation for executives in India and China continues to rise more than 12% a year. The study also suggested that this may be a good time to move to developed world multinational corporations (MNCs); with the differential between expat and local packages eroding, MNCs may be more likely to up their bid.

Last updated: 4 Apr 2014