China Exporting Inflation: Political Spin or Economic Reality?

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

Comments

[mmckinl]

Damned if you do, really damned if you don't.

What we need are tariffs. Let's be clear, if the US continues to have a 6% trade deficit the dollar will continue to fall causing ever more inflation.

These trade deficits are structural not incidental, that is, we are not importing goods to produce or make us more efficient, we are importing goods to consume.

Without tariffs to protect and expand manufacturing here in the US we will be devastated by inflation anyway.

So, take your pick, higher prices with jobs for American made products or ever higher prices for products with fewer and fewer jobs.

[outnow]

Corporation A locates manufacturing in China and borrows money in America deducting the interest. The money earns interest in China where it is not taxed to the subsidiary manufacturing corporation. The product is then "sold" to Corporation A which then sells it in the U.S. market. Corporation A pays almost retail for the product so that little taxable gain is realized for tax purposes.

There results a dramatic erosion of the ability of citizens to maintain their living standard in the environment that their leaders have created. Less investment is made in domestic manufacturing sector.

A governing class gamboled on America's capacity to compete and win would be making larger and continuous investments in order to sell more and better products in the global economy. The governing class would make such investments in the quality and and speed of the workforce skills and would be providing them with privileged access to cutting-edge technology. Yet little of this is happening.

The United States has already lost its once formidable lead in key indicators of competitiveness. The United States has fewer and fewer in the workforce with two years of college and ranks tenth in the world with 25 year-olds with degrees in engineering or natural science.

The pure ideological analysis of the economics of free trade over the policy interests of the working middle class will be the demise of or society. Tax policies cannot be ignored. Class differences in the winners and losers are beginning to become more evident. The CEO benefits more than the worker/consumer. The investment banker profits while your children can buy cheap goods for a while.

[Herrington]

Nicely stated outnow.

[January]

Here's what I saw in this article: "The last five years have been good for us with China. The next couple may be a bit shakier. But it could be that the next ten will continue to be good for us."

Thank you for daring to take the risk of stating some specific time periods. Most of what I read talks in sweeping terms about this way and that way but never putting them in a time frame. And thank you for the identified sources. The complex patterns identified make a whole lot more sense to me than the usual simple rhetoric of journalism.

The suggestion that US business is scapegoating China and will continue to do so also makes sense to me. But I'd much rather have this kind of competition than the one that involves warfare. I'd rather everyone had more to lose by war than to gain from it. As long as we are moving in that direction, I can handle the headaches.

[Henry]

Eban:
You sound quite naive to all of this. The currency of the PRC is not trading at the market price (it should be some 40% up on the USD) because the central bank of the PRC has been intervening to keep their currency at their (not the free market) rate which is commensurate with their economic plan(s). Their central bank has essentially been "monetizing" USA debt. (a prescription for inflation)
If WallMart (for example) had to pay 40% more for imported sweaters from the PRC, what impact do you think this has on domestice USA inflation, you know, the cpi (sweaters)?
The Japanese do this also, and the most immediate take you can have is that this cheats the USA worker(s). And the Bushwa boys permit this!!! This is insane. Do the Texas Rangers play with this handicap put on them?

[kevinabt]

I don't think many people would rather pay more for their goods, even if it meant that they were manufactured in the US. Most people are not actually nationalistic, but are rather individualistic. Favoring benefits for themselves rather than benefits to the nation as a whole. While this may seem short sighted, it is the way a free market works.

Americans are in many ways the winners in this exchange. They get to trade federal reserve notes (which cost almost nothing to create) for real goods. They get a very high standard of living with much less effort. The losers are the Chinesse workers who put in 70+ hours of very hard work a week for minimal return. They are being exploited by their iron fisted government and the foreigners who assist them. Eventually, once enough capital investment has been made in China and they have modern factories, transportation, technology, skilled workers, and all the other advantages western free market countries have the Chinesse will stop accepting federal reserve notes in trade. Having no need for the products of the US (petrodollars, technology) they will stop shipping their manufactured goods to the US. The US will then be in a situation where it has little to trade and a diminished ability to produce the things it needs itself. There will once again be demand for US manufacturing jobs, Hurray! But the workers will not be compensated very well, what will they be compensated with? Federal reserve notes that no other country will want? The small ammount of manufactured goods that are created locally? Who knows. There will be jobs for Americans again, but the standard of living will be way down.

Right now the US has the upper hand, but soon the countries and people who actually do the work and produce useful goods and services will be the ones benefitting.