Once an Exporter of Products, China Now Leading Global Exporter of Inflation

By Jason Simpkins
Associate Editor

Cheap raw materials and ultra-cheap labor helped China earn its reputation as the supplier of low-cost products to the world, but rising domestic prices have touched off an inflationary epidemic that is infecting the U.S. economy.

"China has been the world's factory and the anchor of the global disconnect between rising material prices and lower consumer prices," Dong Tao, an economist at Credit Suisse Group (CS), told the New York Times. "But its heyday is over. We're going to see higher prices."

After falling for years, the prices of Chinese goods sold in the United States have risen for the past eight months. The rising costs of energy and raw materials, new regulatory policies, and a weak U.S. dollar have combined to drive the prices of Chinese exports sharply higher.

About 7.5% of all consumer goods sold in America are made in China, and even where Chinese products account for a small share of the market, their low cost often forces other producers to keep the sticker prices of their own wares down in order to stay competitive. So it stands to reason that when the price of China-made imports begin to move higher, rivaling producers are free to push their own prices northward, as well.

China wields much more influence on the U.S. economy than most investors realize. For instance, a mere 2.4% up tick in the cost of China-made products last year was more than enough to help the U.S. inflation rate to escalate as well - from 2.5% in 2006 to 4.1% last year.

Producer prices surged a hefty 5.4% in December, the biggest jump in 31 months, according to a government report.

So just what exactly has caused the assembly line to the world to shift its chief export product from low-priced consumer goods to rising inflation?

And what are the chances that this new product features a "no-return" policy, meaning U.S. consumers will be stuck with it?

After all, inflation isn't exactly something that one can easily "re-gift."

As it turns out, there are three key inflationary catalysts:

  • Red Tape and Regulatory Scrutiny.
  • Energy Inefficiency.
  • Inflation at Home and Abroad.

Let's look at each of the three.

Inflationary Catalyst #1: Red Tape and Regulatory Scrutiny

A new wave of government reforms is an integral catalyst for the dramatic price increases in China. After key trading partners have harangued China for years about its ballooning trade surplus, the Chinese government reduced - or removed outright - the tax rebates on hundreds of export items, including toys, clothing, leather and wood.

In addition to now taxing some of its chief export industries, Beijing also has responded to a range of humanitarian concerns by raising wages and strengthening workers rights.

The government has closed a loophole that permitted companies to lay off - without severance compensation - workers the firms had hired on a temporary or a fixed-term basis. Workers employed by a company for 10 years are now entitled to one month's severance pay for every year worked. And employers are required to consult an "Employee Representative Congress" when considering changes in hours, benefits and compensation. The new labor law took effect in January.

Willy Lin, managing director of Milo's Knitwear (International) Group, told the Financial Times that the new labor law could increase costs by as much as 8% this year.

"We estimate that, added together, labor costs [in mainland China] will be close to 40% higher for this year," Lin said.

In some parts of China, industry experts estimate that factory wages have jumped by 80% or more. Even from their low starting base, that's a significant increase in wage costs.

Health and safety risks are creating additional challenges for Corporate China. The country's double-digit economic growth is one reason China made headlines last year, but the nation's pollution epidemic and product-safety scandals resulted in just as much publicity.

As a result, Beijing has increased industry inspections to ensure compliance with environmental and safety regulations. Hundreds of factories were shut down last year because of quality inspection problems.

Some factory owners are considering moving their operations further inland or to other parts of Asia where costs are lower, but uprooting large factories from their supply chains and work force is a grueling process that could take years to accomplish.

Companies that outsourced production to China in the 1990s and exploited the dramatically lower production costs to make their fortunes are being forced to accept that their free ride is coming to an end.

"This is what I call the ‘perfect storm'," Alan Hassenfeld, chairman of Hasbro Inc. (HAS), the world's second-largest toy maker, told the International Herald Tribune.  "We've got higher labor costs and labor shortages, plastic prices have gone way up and we're doing more safety testing."

The price of plastic has risen 30% in the past year, but it's not the only commodity that has made life tougher for industry in China. Commodity prices have skyrocketed across the board and now a coal shortage is wreaking havoc on the economy and is further hindering China's production.

Inflationary Catalyst #2: Energy Inefficiency

 Coal is responsible for 78% of China's energy output, but it's also the primary source of energy in other emerging nations - such as India. Coal accounts for about 69% of India's total energy supply.

A dramatic spike in demand has transformed what was once a dirt-cheap commodity and energy source into a sparkling investment opportunity that professional traders have crammed their way into like an express commuter train to Connecticut.

Little wonder the price of coal has responded with an express train acceleration.

Last week, coal prices jumped to a record high of more than $100 per metric ton at Australia's New Castle port, a benchmark for Asia. The week before that, power-station coal prices at the New South Wales port climbed $23.09, or 25% to close at $116.44 per metric ton - the second straight week of record prices there, according to Bloomberg News.

The price of coal coming out of South Africa's Richards Bay Coal Terminal, the world's largest, rocketed nearly 90% last year. According to the Global Coal New Castle Index, coal prices soared 73% in 2007. Prices there have been further exacerbated this year by national power shortages that have forced mines to shut down.

Factor in some recent events in China, and news on this portion of the energy front only gets worse.

On the eve of its huge annual Chinese New Year national holiday, portions of Mainland China were devastated by the worst blizzard of the past half-century. Three weeks of snowfall killed at least 60 people and cost the country approximately $7.5 billion.

Major railways and roads have been shut down, and 7% of China's coal-fired power plants have come offline. Less than 25% of the daily demand for coal shipments by rail has been met in the past week, the Ministry of Railways reported. And traffic congestion during the Chinese New Year also slowed deliveries last week.

Zhu Hongren, a senior official from the National Development and Reform Commission, said that no less than 17 provinces have suffered power shortages and 13 provinces have been forced to ration power.

The country has been forced to restrict its coal exports to boost domestic supplies.

"It's all stemming [from] China, where it looks as if they've got some real problems," Graham Wailes, a coal analyst at AME Mineral Economics Pty in Sydney, told Bloomberg News. "South Africa is having its dramas; the pressure's on, it's a bit of a short-term squeeze."

The five biggest electricity producers shut 90 power stations with combined capacity exceeding 20,000 megawatts in northern and central China, according to the State Grid Corp. of China.

Also, like toy companies, China's coal-fired power plants have faced an increasing amount of regulatory scrutiny because of environmental concerns. A study conducted by the World Bank, concluded that air pollution from coal-fired plants is responsible for more than 400,000 premature deaths every year. That number was subsequently raised to 750,000 just weeks after the report's release.

China is home to 16 of the 20 most-polluted cities in the world, and last year, the nation became the No. 1 emitter of greenhouse gases on the planet - a title that the United States held for more than 100 years.

A stricter regulatory environment, rising fuel costs, frequent brownouts, and supply bottlenecks have made energy both more expensive and less reliable, crippling the country's industry even as it escalates costs.

Inflationary Catalyst #3: Inflation at Home and Abroad

Inflation in China reached an 11-year high of 6.9% last November, more than double the central bank's target. The inflation rate abated slightly in December, dropping to 6.5%. The incoming inflationary tide has forced the central bank to raise interest rates six times in the past year. 

However, it seems no matter how far, or how fast, the yuan falls, the dollar falls faster. The dollar has dropped about 7.6% against the yuan in the past year, and is expected to fall even further this year. And the weaker the dollar gets, the more expensive Chinese goods become for U.S. consumers.

While the Bank of China is raising rates in a desperate attempt to subdue inflation and stave off social unrest over high food costs, the U.S. Federal Reserve has been forced to boost liquidity and slash rates on an emergency basis.

Central Bank Chairman Ben S. Bernanke and Fed policymakers cut rates by a total of 1.25% last month, moves that further fueled inflationary fears in the U.S. market. Consumer-price inflation climbed above 4% last year. And U.S. gross-domestic-product growth braked to a woeful annualized pace of 0.6% pace in the fourth quarter.

China's import growth rose significantly in the second half of 2007, while export growth declined. The increase in growth of imports outpaced that of exports for three consecutive months in the fourth quarter, according to the World Bank.

Wang Tongsan, director of the Institute of Quantitative and Technological Economics of the Chinese Academy of Social Sciences (CASS), told Xinhua that "a drop of one percentage point in American gross domestic product would lead to a five percentage-point decline in the growth rate of Chinese exports."

In addition to taxing exports, low U.S. interest rates will make it more difficult for the Central Bank of China to continue to defend against its own inflation problem. 

"The aggressive series of rate cuts by the U.S. Federal Reserve would limit China's use of the interest rate lever," Wu Xiaoling, former vice president of the People's Bank of China, told Xinhua. "Other measures might be taken to control the amount of money circulating in the market."

The bottom line is that the United States and China have joined hands in creating a classic Catch-22 situation of which the late U.S. author Joseph Heller would've been proud - this Catch-22 is global in both nature and scope. The negative effect of the weak dollar has become circular: U.S. inflation has helped to make Chinese goods more expensive, and those more-expensive Chinese goods are amplifying U.S. inflation.

U.S. consumers can expect prices to increase, meaning that their paychecks won't stretch as far. Corporate profits will likely suffer, and if that happens, U.S. stock prices will sink still more, as well.

Related News and Story Links:

  • Forbes:
    Problems In Black And White For China
  • Forbes:
    Coal Prices May Double In Coming Year