China has an inflation problem.
The country raised the reserve requirements for its banks at the weekend yet again. The move comes just after Beijing raised interest rates for the fourth time since October. And it’s also been using state subsidies and price controls to keep food prices in check as best it can.
So why should you be worried? Two reasons. For one, China’s inflation problem isn’t staying in China. It’s going global.
Secondly, there’s the question of what China decides to do to rein in its inflation problem – and what that could mean for the rest of us.
China’s inflation is spreading
China’s inflation problem is fast becoming the world’s inflation problem.
The country’s economy is still growing faster than expected. GDP growth came in at 9.7% for the first quarter of 2010. That was down on the 9.8% seen at the end of 2010, but higher than the 9.4% expected by analysts.
More importantly, inflation came in at an annual rate of 5.4% in March, from 4.9% in February. This may not seem like that much, but prices are now rising at their fastest rate since 2008. This looks set to continue.
And that’s something we should all be watching. Brian Coulton at Legal and General Investment Management warned last week that the threat of rising prices from China is being underestimated. As “inflation becomes more and more of a concern in advanced economies, China is going to be making things worse”.
The trouble is, we’ve become used to the price of consumers goods falling almost constantly. In the early part of this decade, that helped keep inflation in the developed world tame, as it offset the effects of loose monetary policy from Western central banks.
Yet now that the trend is reversing, pundits seem to assume that China doesn’t matter any more. Any price inflation is largely due to commodity price rises, which are ‘temporary’.
Companies are passing on rising costs
But that’s a little optimistic. Soaring raw materials prices are one thing. Those can be dismissed by the authorities as a volatile ‘one-off’ factor (even if they continue for a very long time, as they have been recently).
But with supplies of cheap Chinese labour running low, wage inflation in the country is harder to shrug off. Wages are ‘sticky’ (they have no problem going up, but you’ll have a hard time pulling them back down). On the one hand, the pool of young labour is drying up. That’s partly down to the ‘one-child policy’ (so much for the wonders of central planning).
The other problem you have is that with young people moving to the cities, the workers left behind to work the land in the countryside are also able to command higher wages, because there are fewer of them. That also drives up the price of food production.
And the higher costs rise, the more likely companies are to feel forced to pass on the costs to their customers. Take Compal Electronics, the world’s second-largest contract PC maker. The company is raising its prices, according to the weekend FT. The ‘rare’ move comes “in reaction to the disruption in the technology supply chain after the Japan earthquake, rising wages in China, and soaring prices for raw materials”.
The company makes PCs for the likes of Acer, Dell and Hewlett-Packard. It’s now negotiating for higher prices with its customers. And this is despite the fact that PC sales are being hit hard by competition from tablets (like the iPad) and smartphones.
Given the fall in sales, says one analyst interviewed in the FT, there is “no way [these companies] are going to be able to pass this on to consumers”. But that either means that profit margins fall (which would be bad news for share prices) or they start cutting back on the specifications of the computers they sell. In other words, you’ll start being charged the same price for less computer. It’s a bit like decreasing the size of a chocolate bar and charging the same price for it – it’s inflation by stealth.
What does it mean for investors?
With prices rising across the global supply chain, more pressure will build on the likes of the Bank of England and even the Federal Reserve to start to tighten monetary policy. With Western economies fragile, that might knock the wind out of the sails of stock markets.
Moreover, there’s the question of what China will do. The country’s anti-inflation rhetoric is ramping up. The authorities are particularly concerned about food price inflation, which has the most potential to result in social unrest. As The Economist points out: “food prices are rising at a 12% annual rate… an unsettling development in a country where households spend a third of their budget on food items”. Beijing is even allowing the renminbi to rise steadily against the dollar in the hope of cutting commodity import costs.
The danger facing the country is clear. If it tightens too late, inflation takes off, and social unrest explodes, setting the stage for a hard landing. If it tightens too hard and fast, economic growth collapses, bad debts surge, and yes, we get a hard landing.
Of course, as we’ve noted before, a hard landing in China might not be such a bad thing for the West. If China’s economy slowed, commodity prices would likely fall, which would provide Western economies with some breathing space. However, many companies’ share prices now depend greatly on the continued strength of China – both the luxury goods and mining sectors would fall hard.
It’s another good reason to stick with defensives – these companies can withstand higher inflation better than others, but they’d also do very well if costs were to come down in the event of a Chinese economic crash. And with China’s citizens increasingly worried about inflation, their appetite for gold should increase too, as my colleague Dominic Frisby recently pointed out: The next big driver of gold’s bull market – China’s middle classes.
Our recommended article for today
A great opportunity in bonds
There are two major reasons bonds aren’t in fashion today: the credibility of borrowers, and interest rates. And right now that second point presents a great opportunity for the private investor. Bengt Saelensminde explains.