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Why China May Soon Ditch Its Biggest Export - Deflation

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From MoneyWeek

Inflation is very much in investors’ minds at the moment, and with good reason.

High oil prices and the soaring cost of raw materials have left inflation sitting at the top end of the US Federal Reserve's "comfort zone", just as the country’s housing market is looking distinctly unwell. Investors are worried that if inflation stays at current levels, the Fed will keep hiking interest rates - which is likely to bring the US housing party to a very messy end.

But it's not just about the forces that are driving inflation higher. The bad news is that one of the main factors that has kept a lid on inflation in recent years also now seems unlikely to continue for much longer…

One of the main things that has kept inflation down in recent years – apart from governments fiddling with the statistics, of course – is the rise of China as the world’s production powerhouse.

Access to a massive pool of cheap labour has enabled retailers to slash the prices of everything from shoes to television sets.

But China can’t keep exporting deflation forever. As the country’s economy expands it employs more and more people. That means employers come under increasing pressure to offer more money to secure the best workers. A report from Daiwa Research by Toshikatsu Kimura shows that real wages per employee rose by 13% a year from 1999 to 2005.

The central government is also increasingly keen to enforce minimum wage rules. This is mainly to prevent civil unrest caused by the difference in wages between established city workers and those who are newly-arrived from the countryside.

And if labour costs are rising, that puts pressure on companies to raise the price of the end product too. And that could mean an end all the cheap goods that Western consumers have been taking for granted.

Mr Kimura says that this may harm “China’s competitive edge in labour-intensive industries.” But this may not be such a bad thing. He points out that higher wages mean Chinese consumers have more to spend – “a development that should be welcomed by the Chinese economy, which is beginning to search for a change from the export-dependent model of growth.”

In any case, it may not be that easy for Western countries to find replacements for China as a manufacturing base. Eoin Treacy of Fullermoney.com says: “Of course there are plenty of developing countries lining up for the chance to be the world’s cheapest factory, but none have the scalability of China other than India, which does not yet have the infrastructure to compete in that area.

“The ramifications for developed country markets could be far reaching where we already have covert inflation in terms of house prices, services and energy. Inflation in clothing and manufactured goods would surely show up in Consumer Price Inflation figures.”

(As an aside, anyone interested in reading more about the different challenges facing China and India’s economies, should read this piece we recently published from Morgan Stanley economist Stephen Roach: The biggest risk facing investors in China and India (http://www.moneyweek.com/file/13311))

And as inflationary forces build overseas, Gordon Brown is frantically redoubling efforts to keep wage increases under control at home. The Chancellor has once again warned government departments to keep public sector pay rises at or near the Bank of England's 2% inflation target, for the next three years at least.

His tough-talking on wages came on the same day as government statistics revealed that a full 616,000 working days were lost to strike action in the first three months of this year. That’s nearly four times the 158,000 days lost during the whole of last year.

And – surprise, surprise - 95% of the lost days were due to public sector strike action.

So do the unions look likely to accept what would effectively be a pay freeze (or even a cut, if inflation keeps rising), in real terms? Of course not.

Transport & General Workers’ Union general secretary Tony Woodley said the call for wage restraint “should be seen in the context of the key role played by public sector workers”. He said that public sector investment “must include investment in pay and pensions to public sector workers, who are, in the main, low paid workers.”

We could talk about how public sector wage hikes have far outstripped private sector ones in recent years. We could also point out that the public sector already enjoys incredibly generous pension deals, despite various feeble attempts by the Government to impose minor reforms - all of which have failed in the face of strike threats.

But let’s not go into all that right now. Suffice to say, Mr Brown’s going to have a fight on his hands. As can clearly be seen from Mr Woodley’s comments, people get used to a certain level of pay rise, regardless of how generous it is. They are unlikely to accept a cut without some stiff resistance.

Besides, if China’s workers keep earning at their current rate, we’ll all be demanding higher wages just to be able to afford their no-longer cheap products.

Edited by munimula

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