Inflation: The End to China’s Cost/Price Squeeze

Until this year when inflation finally became a factor, the rapidly rising price levels that typically accompany high-growth economies have been notably missing from China’s economic picture. It is surprising how China has been able to grow its economy at double-digit rates over the past 10 years, employing plenty of fiscal and monetary stimuli, without having to deal with the ravages of high inflation. In three of the past 10 years, inflation has actually been negative; in five it has been less than 1 percent; and in eight it has been under 2 percent. After spiking to 3.9 percent in 2004, inflation declined to 1.8 percent in 2005 and 1.5 percent in 2006.

But ever since the calendar turned at the end of 2006, inflation has become a growing story in China. The rate of inflation in China immediately jumped to 2.2 percent in January, and it has been rising nearly every month since. By October, it had risen to 6.5 percent, and no one knows where it will stop. Food prices are up almost 18 percent over the past year, led by meat and poultry prices, which are up 49 percent since 2006, and housing prices are up 9.5 percent across the country.

China’s last serious bout with inflation came in the early 1990s when the country had double-digit inflation rates for three years running in 1993, 1994 and 1995, reaching a peak rate of 24.1 percent in 1994. The effects on purchasing power and the currency were dramatic. While the official exchange rate of the renminbi to the U.S. dollar was 5.5 at the time, yuan could be purchased on the black market, such as at any number of stalls in Silk Alley in Beijing, at a rate of 14 yuan to the dollar. Zhu Rongji, China’s then economic czar, responded with an aggressive austerity program which severely curbed lending and credit. Zhu’s measures brought inflation down to less than 3 percent by 1997, where it has largely remained until this year, and stabilized the currency to the point where it could be pegged at 8.3 to one U.S. dollar in 1998.

It should come as no surprise that inflation has now become a factor in China. The price of crude oil is now $100 a barrel, and for an economy like China’s, which is not nearly as energy efficient as that of the United States, the impact is that much greater. High energy prices and fears of global warming have encouraged greater production of alternative fuels like ethanol in the United States, driving grain prices on the world markets ever higher. In a globally-connected world, higher grain prices in the United States mean higher grain prices everywhere, and therefore higher food prices overall in China too.

Apart from oil, the price of nearly every raw material has doubled or tripled since 2004, which in China’s manufacturing, resource dependent economy has lead to a significant increase in costs. Yet, due to severe competition and customer pricing pressures, prices for manufactured products in both China’s domestic and export markets have declined or had only modest increases. The fact is that Chinese manufacturers have been in a massive cost price squeeze over the past three years, with the prices of everything they produce going down, and the cost of every raw material they use going up.

Profit margins have suffered and manufacturers of all types of products have taken it on the chin. A recent study by an automotive trade group found that profit margins for the top 50 automotive components companies in China have declined by five percentage points since 2004. Profit margins in the electronics industry have always been relatively low, but are now razor thin.

While I have not done a comprehensive survey, my guess is that profit margins across a broad range of manufacturers have been similarly impacted. Something had to give, and it was only a matter of time before manufacturers began to pass along some of these increased costs to consumers.

In a recent article, Time called inflation China’s “next big export.” The article quotes Ben Simpfendorfer, China strategist for the Royal Bank of Scotland, as saying “Where China was a deflationary influence over the last 10 years, it will be an inflationary influence over the next 10 years.”

While demand in China has certainly increased overall global demand, and therefore global inflationary pressures, it’s not quite fair to blame China for rising prices. Over the past 10 years, the country’s manufacturers have single-handedly taken down global price levels significantly. Consumers the world over have benefited from the deflationary forces coming out of China through lower prices, but they should regard what has occurred as a one-time adjustment of global pricing levels. Once the bulk of manufacturing has switched from high-wage economies to low-cost countries, further price reductions from labor savings are no longer to be had. With prices and manufacturer profit margins now at rock bottom levels, any increases in costs must be passed along to the consumer.

Although the Time article focuses on wage increases in China as a major contributor to inflation going forward, I don’t believe that wages are nearly as big a factor as raw material prices. Despite their substantial increases over the past several years, prices of iron ore, copper, oil and just about every other raw material used in manufacturing, construction and agriculture keep rising. Until raw material and commodity prices stabilize, China and the rest of the world will have to get used to a higher level of inflation.

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