International | Jul 02 2007
By Greg Peel
The Western world continues to see inflation as the greatest threat to a healthy global economy, but core inflation measures continue to surprise on the benign side. It is no secret that mature economies have enjoyed relatively low inflation rates in past years, in the order of 2-3%, despite rising commodity and oil prices as a result of China recycling materials into cheaper and cheaper exports of consumer goods.
The deflationary effect of Chinese exports has been fuelled by cheap labour, easy financing, and little control over the multitudes of competing manufacturers that have simply appeared overnight across the country. These competing manufacturers are running on margins that are so tight the slightest changes in the currency can bring many of them down. It is for that reason that China has maintained an artificially low renminbi while implementing incremental measures to curb competition and control cheap finance. China is trying to control its economic runaway train, but doesn’t want to go as far as triggering a hard landing.
The Chinese government has also been at pains to encourage domestic consumption as a buffer against constantly increasing foreign reserves. The Chinese economy becomes even more perilous if the global trade imbalance persists and the government can’t get the locals to consume some of what is currently being exported. While sales of goods like cars and fridges have jumped markedly, China is still a relatively poor nation and the cultural tradition is to save money rather than spend it.
While any increase in domestic consumption would affect an increase in domestic inflation, this inflation would be of the healthy variety, allowing interest rates to rise and the currency to revalue with less of an impact on the global imbalance. However, one of the greatest dangers to China is that domestic inflation increases without any marked increase in consumption. And that’s exactly what’s happening.
The consultants at GaveKal remain long term bullish for the global economy but have suggested in the past that one of the greatest threats to “Goldilocks” is the rise of food inflation in Asia. The price of food has a greater impact on the Asian weekly budget than it does in the West, given that the Chinese, for example, still need to eat as much as we do but still earn a lot less. Hence food inflation has a greater impact on domestic consumption and that’s exactly what the Chinese government does not want.
The current surge in global food prices has a lot to do with various droughts and floods but it also has very much to do with the surge in demand for ethanol. Increased grain prices flow right through the food chain. For example, it costs more to buy the grain to feed the chickens that lay the eggs, and hence eggs cost more.
Indeed the price of eggs has risen by 37% in China in twelve months. Meat and poultry – which many a poorer Chinaman has just been able to add to his diet given an improvement in wages – have risen 26.5%.
Associated Press reports the government has ordered local authorities to submit plans for raising minimum wage levels across the country in order to offset the impact of food inflation on low-income families. This will be implemented on a province by province basis, given the disparity across the have and have-not regions of China. Currently the minimum wage in the business centre of Shenzhen is US$106 per month, whereas rural Jiangxi only offers US$35 per month.
Of course, a rise in wage levels is itself inflationary, which suggests that China will likely need to step up its painfully slow program of interest rate increases and currency revaluation. However, even the smallest adjustments in the renminbi will cause many a marginal business, from steel-making to footwear, to hit the wall. While natural attrition is not a bad outcome in a country where competition has run riot, the 10% level of economic growth could collapse pretty quickly if businesses start turning up their toes to any great degree. This would then reduce Chinese demand for raw materials, and hence impact on the global economy.
The world has always been waiting for Chinese inflation. The assumption has always been that higher and higher commodity prices simply must eventually be passed through to higher prices for Chinese exports, but to date the Chinese have largely absorbed these costs by letting their margins erode to nothing in order to just keep recycling cash into debt obligations. The whole system is perilously balanced. However, what was not necessarily foreseen a year or so ago was the rise in the demand for ethanol, which is a response to the high price of oil, which is largely a result of increased Chinese manufacturing. The end result of all of this is increased food prices.
The world has also been expecting a significant global reduction in foreign investment in US dollar assets, if for no other reason that countries in Asia and the Middle East keep suggesting just that. The odds of a hard landing for the global economy keep increasing every time Chinese export receipts and Middle Eastern petrodollars keep being invested back into the global reserve currency. However, the figures indicate that so far it’s been a case of a lot of talk and little action. Although in the case of China, so quickly are foreign reserves growing that any shift into other currencies or commodities has little impact on amounts still being placed into US Treasuries.
Reuters reports that the European Central Bank noted this week that foreign investment in the euro has remained stable since 2005, suggesting that the US dollar is still the currency of choice amongst central banks. As yields on US Treasuries have begun to rise, the assumption has been that this is due in part to foreign divestment. However, the numbers do not bear this out.
US strategists are not now expecting specific foreign selling of US dollar assets. They are, however, expecting a reduction of reserves being channelled into the US, which is still negative for bond prices and the US dollar. In the meantime, China, for one, will need to keep revaluing its currency.
The irony is that while many in the US are calling for protectionist measures to curb the Chinese machine, any revaluation in the renminbi will mean higher export prices for voracious US consumers and hence a reduction in spending. It would also precipitate a fall in the US dollar which reduces the average American’s purchasing power once again. If Americans stop spending, the global economy is not looking so rosy.
