Why You Should Care About Chinese Inflation

By Stephen D. Simpson, CFA | April 27, 2011 AAA
Why You Should Care About Chinese Inflation

Back in the day, a snooty professor might have responded to an irrelevant or impertinent question by asking "What's that got to do with the price of tea in China?" As it turns out, the price of things in China is hardly irrelevant anymore and Chinese inflation is increasingly looming as a threat to economic stability and growth. (For background on inflation, see Inflation: The Inside Story.)

TUTORIAL: Economics Basics

With so much to worry about at home, to say nothing of the ongoing debt crises in Europe, is there really a need to worry about one more thing? Given the size of China's economy, it's role as a major exporter of goods (and importer of materials), and its role as a financier of other countries' deficits, the answer would seem to be a definite "yes."

Inflation on a Long March in China
According to the official numbers, inflation hit a rate of 5.4% in China in March, the highest level in about 3 years. While that is far off the record high level of nearly 28% back in 1994, it's still a level that has investors, businessmen and officials worried.

More worrisome still is the probability that, like in the U.S., Chinese official inflation rates are understating matters by a significant amount. Wages have been rising by high single-digit percentages and property values are soaring. In fact, housing prices in some areas of China are reaching a level of 25 times median incomes - a level more than double the peak bubble ratios in many U.S. markets. (Learn more about why some government numbers may be less than credible in 5 Government Statistics You Can't Trust.)

Whatever the real rate of inflation, it is clear that the government is trying to bring it down. The bank reserve rate is now at a startlingly high 20.5% and one-year deposits in China are paying about 3%. What's more, there are ample reports of the government moving against organized labor (to keep wages down) and attempting to induce rural farmers to send more food to the cities.

Why We Should Care? There are a lot of reasons.

Higher Chinese Wages Mean More Expensive Goods for Us
A lot of products on store shelves in North America come from China, and generally low margins among Chinese manufacturers and assemblers means that there is little leeway to absorb higher costs. That means that the higher price of doing business in China is soon to be seen on the shelves of Wal-Mart (NYSE:WMT) and Best Buy (NYSE:BBY). Though manufacturers are already looking to move some production to even cheaper countries like Vietnam and Bangladesh, it takes time to restructure a production chain.

Better Opportunities for North American Exports?
If Chinese goods get more expensive, it stands to reason that North American exports will be more competitive. That could be especially good news for industrial companies and technology companies looking to sell into Europe and emerging markets. It could also be a good opportunity for companies like Emerson in the factory automation space if Chinese manufacturers look to supplant increasingly expensive labor with machinery.

Along similar lines, if Chinese goods get more expensive and consumers stop buying as much, it could improve the trade imbalance - though there is the risk that consumers still pay the higher prices, don't cut spending as much and go into debt all over again.

A Revaluation of the Yuan?
At some point the Chinese government may have no choice but to revalue the yuan. Though this would likely not be the panacea that some government officials in the U.S. seem to believe, it would nevertheless likely be a stimulative benefit to the U.S. economy. It would also likely reduce the flow of investment funds into China, while lowering the cost of the country's imports.

TUTORIAL: Economic Indicators To Know

The Risk Of A Bubble
Information on China's property sector has always been a little wonky (with big discrepancies in "median income" for instance), but it looks like there are legitimate bubbles in many parts of China's real estate market. Perhaps some of this is just a product of the migration to the cities that occurs as countries industrialize, but one need only look at what property bubbles did to banks and the broader economy in Japan and the U.S. to see the danger.

Instability
Moreso than in the United States, inflation in China carries a risk of social and political instability. As much as the media talks up China's rising economic power, many do not realize that a lot of Chinese still live in rural areas that are quite poor and underdeveloped. More to the point, it seems that the Chinese people are generally willing to abide by authoritarian one-party rule so long as they enjoy rising standards of living and have the opportunity to get wealthier.

Rising inflation is a significant threat to that social contract. China still has a large number of poor people for whom food is a major expenditure. Just ask rulers in North Africa and the Mideast how authoritarian governments fare when the people have had enough of them and food prices are too high.

Likewise, China's inability to balance goods inflation with wages is starting to cause problems. The government seems to have tried to intervene in attempts for labor to organize and secure better wages, but the cost of goods on the shelves are rising. That has led to sporadic unrest and protests, including a recent protest of truckers that got somewhat violent.

While some in the U.S. and Canada may chuckle about this new headache and challenge for Chinese leadership, it's a dangerous situation. China is a huge trading partner and the global economy cannot afford to have China unsettled by internal strife.

The Bottom Line
For better or worse, the linkages and interdependence of the global economy means that what happens in China matters here as well. If nothing else, it looks as though "cheap China" is becoming increasingly difficult to maintain and that the Western world can no longer look to the substitution of cheap Chinese imports as a means of tamping down global inflation.

This process of adjustment could be very unsettling to the global economy, and not just in segments like the commodities market. After all, China is a major buyer of our debt and may not be able to expand its own money supply to continue that practice. Then again, this could be a boon to American exporters and an unexpected stimulus to our economy, as well as a new opportunity for countries like Vietnam and Bangladesh and perhaps some in Africa as well. Either way, it certainly matters to us. (To learn more about statistics that can cause market movements, check out 4 Key Indicators That Move The Markets.)

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