Sunday, June 10, 2007

Waning of China Effect will result in Higher Inflation and Interest Rates

In October 2006, the world's biggest container ship, the Emma Maersk, owned by A.P. Moeller Maersk of Denamrk, docked for the first time in the UK port of Felixtowe loaded with nearly 45,000 tons of Chinese-made goods including MP3 players, computers, Christmas trees and crackers.

The Emma Maersk, which is 400 metres long (1,300 ft), 56 metres wide and 60 metres tall, and dubbed the SS Santa, unloaded more than 3,000 containers for supermarkets and stores before heading to mainland Europe.

While migrants have kept labour costs down, in recent years, the falling price of goods that are imported from Asia, led by China, have contributed to the fall of inflation in the Developed World.

The fall in goods prices and impact in inflation in the Developed World, is known as the China Effect.

Prices of clothing and footwear sold in Ireland have fallen by 36% since 1996. Household appliances are down by about 25%; toys are 30% cheaper, and of course, in the audio-visual category, products are on average now 56% cheaper than they were in 1996.

The latest report on Irish consumer price inflation shows that in May, service inflation rose by 9.15 while the price of goods fell by 0.3%.

A 2005 study by Dresdner Kleinwort Wasserstein reckons that China has knocked almost a full percentage-point off America's inflation rate in recent years. The recent 2% revaluation of the yuan will probably be absorbed by Chinese manufacturers trimming their profit margins and so will not be passed on into export prices. But Americans calling for a 25-30% revaluation may come to regret it: the result would almost certainly be faster inflation.

China's reduction of inflationary pressures has allowed central banks to hold interest rates lower than they otherwise would be. Three and a half years into its recovery, America's real short-term interest rates were only 0.7%, almost two percentage-points below their average at the equivalent stage in previous recoveries since 1960.

The question now is how long will the China Effect last and keep interest rates in Europe and the US lower than they would be if goods inflation was higher?

An article in the New York Times on Friday, June 8th, says that the recent rise in China’s pork prices signals an end to cheap output.

The NYT says that business executives say that with wages rising 10% or more a year in many Chinese cities, the country’s days are numbered as the world’s lowest-cost producer of many cheap labor-intensive products, like toys and shoes.

Last autumn, Governor of the Bank of England Mervyn King said in a speech:

Over the past decade the integration of China, India and other emerging markets in Asia into the world trading system has lowered the prices of clothes, electrical goods and other items that we import from them. The terms on which we trade with the rest of the world improved. That provided a boost to real disposable incomes and so to consumer spending. But the rapid growth of China and India also meant sharp increases in the prices of many commodities, such as copper, aluminium, iron ore and, particularly important, oil.

In that sense the rises in oil prices over the past two years are very different from the oil price “shocks” of the 1970s. They reflect rapid growth in the demand for oil – faster than the growth of capacity – rather than an OPEC-inspired contraction of supply. What we have seen is not so much an “oil shock” but a consequence of the rise of China.

The lower prices for many consumer goods and the higher cost of oil are both the result of globalisation. Having benefited from the former we are now experiencing the latter. As a result, our import prices are no longer falling as rapidly as they were, and, indeed, over the past year even the prices of non-oil imports have risen. With the additional impact of higher oil prices, real disposable incomes are rising more slowly, and the long awaited rebalancing of the economy away from consumer spending to business investment and net exports is underway.

“People tend to underestimate the deflationary impact over the last 10 years” from Chinese exports, said Michael R. P. Smith, the chief executive of HSBC’s Asian operations told the New York Times. “It has got to the limit: you’ve had wage inflation, you’ve got rising natural resource prices. There’s just no more give.”

The message is that interest rates may have to be increased to a higher rate for a more sustained period, if the positive impact of falling prices of imports from Asia wanes.