China Exporting Inflation: Political Spin or Economic Reality?

03/28/2008 02:48 am ET | Updated May 25, 2011

It's probably fair to say that the most important diplomatic relationship in the world is between the U.S. and China. Unfortunately, the relationship is souring and could get much worse. "Alas, the U.S. is mostly to blame for this," said Nicholas Kristof in a New York Times column. "There are plenty of legitimate reasons to be angry with China's leaders, but its trade success and exchange rate policy are not among them. The country that is distorting global capital flows and destabilizing the world economy is not China but the U.S." He adds: "American fiscal recklessness is a genuine international problem, while blaming Chinese for making shoes efficiently amounts to a protectionist assault on the global trade system."

China has been a convenient scapegoat for politicians lately, and now China, with its crawling peg to the weak dollar, is being blamed for exporting inflation. Is this political spin, or is there a real danger of importing higher inflation from China? Why are some so eager to blame the Chinese for higher inflation when the Fed's policies could be to blame for rising prices? Will China continue to produce cheap goods, or will we see a tsunami of inflation as predicted by the doom and gloomers? These are very important questions for investors wishing to hedge against inflation. If the doom and gloomers are right, gold prices could skyrocket and stagflation could become a reality.

"In a number of respects China has been extremely good for the developed economies over the past five years," explains Jeremy Warner at The Independent. "By producing an ever expanding quantity of cheap goods, it has helped keep prices low. This deflationary effect has allowed central bankers to maintain low interest rates, which in turn has allowed consumer demand to remain high."

But the glory days of low-cost imports from China are coming to an end, and Chinese inflation is taking a turn for the worse. China's consumer price inflation index for January hit an 11 year high at 7.1%. Although non-food price pressures remain mild, the central bank is concerned that inflationary expectations are rising and that higher prices will spread, destabilizing the economy with potentially serious social and political implications. Add in higher raw-materials prices and rising wage costs, and manufacturers are facing increases in production costs they may no longer be able to absorb. Chinese manufacturers may decide to pass on higher costs to consumers worldwide, a situation that will be made worse by a strengthening Chinese currency.

Input costs might be rising fast in China, but some economists believe that labor productivity and efficiency is increasing even faster, which tends to limit manufacturers' need to raise prices. A World Bank study released in October 2007 on raw material prices, wages and profitability showed that "the ability of China's industry to offset rising raw material prices by increasing efficiency has so far remained undiminished."

As long as China can improve efficiency, it won't have to raise prices. But a recent Reuters article suggests that this notion is wishful thinking. The article notes that efficiency at China's listed manufacturing companies peaked last year and has already started to deteriorate, meaning that China could soon start passing on higher costs. Recent industry surveys confirm this idea. According to Global Sources, the Hong Kong trading company, 80% of 709 Chinese exporters surveyed late last year said they expected to increase prices within six months of the survey.

Some commentators point out that Chinese export prices remain steady when expressed in yuan terms, but export prices turn higher when expressed in dollars. As the Economist added: "It is the weak dollar, not cantering cost inflation in China, that is to blame for higher American import prices. China's manufacturing costs and exports prices in yuan terms are still falling overall." (August 2, 2007) Although a weaker dollar should lead to inflation, the relationship is not that simple. According to a recent Wall Street Journal article, there is evidence to suggest that foreign exporters are willing to adjust prices to hold on to U.S. market share as the dollar declines in value. This is especially true when the U.S. economy is slowing and consumers are less willing to pay higher prices. The implication here is that Chinese manufacturers might be hesitant to pass on higher input costs, for fear of losing U.S. market share.

There are also geopolitical shifts to consider. If China fails to increase efficiency to cope with higher input costs, these costs might be passed on to consumers worldwide, and China's competitive advantage might begin to diminish faster than experts thought. Such a development may raise doubts about China's long-term ability to conquer the world.

But if we are to discuss China's long-term ability to conquer the world, it is important to differentiate between short-term and long-term effects. Even if China's rising input costs are passed on in the short-term (next 2 years), the structural changes in China's manufacturing might have a deflationary impact in the longer term. Standard Chartered economist Gerard Lyons says that China's move into more valuable manufactured goods such as automobiles will, in years to come, have the same deflationary effects on world markets as the country's push into low-end manufacturing. Such a development might maintain China's competitive advantage.

In summary, China will probably start passing on higher costs in the short-term, but it's too soon to jump to a conclusion that this change will be permanent. There is still room for China to improve efficiency over the next decade. A survey carried out in September by the People's Bank of China showed that the technological capacity of Chinese enterprises was relatively low compared with foreign counterparts and that companies still had potential to raise efficiency. As long as China improves efficiency in the next decade, a necessary condition for its exports to remain competitive despite rising input costs, the country may continue to be a source of deflation.

Disclaimer: I have no exposure to China