The initial knee-jerk reaction to China’s rather cryptic announcement that it proposes to be more flexible on the value of the yuan has faded very rapidly. That’s hardly to be wondered at, given the scepticism with which the report was received. The typical response was that China wasn’t really serious about any meaningful appreciation and the announcement was merely aimed at deflecting criticism of its currency policy ahead of the Group of 20 (G-20) summit. Many were even more cynical, pointing out that the yuan’s dollar peg wasn’t really helping the Chinese because the yuan was appreciating rapidly against the euro. Others looked at the period 2005-08 when the Chinese currency was allowed to appreciate and pointed out that China’s current account surpluses kept rising at that time and its foreign exchange reserves reached gargantuan proportions despite all the talk of a stronger yuan helping prune global imbalances.
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But this time around, there are other, more powerful, forces at work. This time the effect of the currency appreciation will be reinforced with rising wages in China. For the last couple of decades, China’s super-efficient, ultra-low-cost export machine has helped keep prices in check throughout the world. Chinese prices for a vast range of manufactured goods became the world’s prices. The so-called Great Moderation in inflation owed a lot to China. And given China’s teeming millions in the hinterland, the consensus was that Chinese wages and, therefore, Chinese costs, would remain low for a very long time indeed. On the other hand, China’s huge appetite for raw materials was expected to give a huge boost to commodity prices. In the markets, this trend of inflation in raw materials and deflation in finished goods was expressed in an aphorism: “Buy what China buys, sell what China sells.”
But things have changed rapidly in China. Wages are soaring and costs are rising. Companies complain bitterly that margins are no longer what they used to be. Skilled labour shortages are reportedly severe. To be sure, productivity gains could help offset some of the wage pressure, but these have already been high and the scope for further improvement may be limited. To cut a long story short, people are already talking of the end of an era, as higher wages in China exports inflation to the rest of the world.
Graphic: Naveen Kumar Saini/Mint
There’s no reason why China will not follow its predecessors in Asia and move up the value chain, just as Japan, South Korea and Taiwan have done, although China’s enormous size will make its trajectory different. But the question is: Has the trend of higher export prices already started?
One way to answer that question is to look at the data supplied by the US Department of Labor on US import price indices. US import prices in May were up 8.6% year-on-year. Most of the rise was due to fuel imports, prices of which rose by 33.9% year-on-year (y-o-y). The price index for non-fuel imports was up 3.6% y-o-y.
Taking a look at import price indices by locality of origin, we find that the price of imports from China in May increased by 0.2% y-o-y. Import prices from the Association of Southeast Asian Nations region were flat over the same period, prices of imports from Japan were up 1.8%, from France 1.5%, from Germany 4% and prices of manufactured articles from Mexico 0.7% y-o-y.
Month-on-month (m-o-m) changes show a higher degree of inflation. For instance, the price of imports from China in May compared with April moved up by 0.3%. Similarly, in April, this price index had moved up by 0.2% compared with March. In the two previous months, however, the m-o-m change was negative. The price of manufactured goods imported into the US from industrialized countries rose in May by 0.5% m-o-m and in April by 0.6%, while those from other countries rose by 0.1% in May and 0.6% in April. Taking both the months together, that’s still higher than the rise in prices of imports from China. Clearly, while Chinese wages are certainly rising, that has not so far translated into price inflation for its exports, although the May numbers do show a jump.
There could be several reasons for this. Margins for Chinese manufacturers are shrinking. If so, this could help move factories to other lower-cost countries, especially since margins are already razor-thin. Two, the so-far rock solid Chinese yuan has been helping keep Chinese prices down. And three, it’ll take time for higher wages to be reflected in higher prices.
A rising yuan will, of course, compound this effect. John Ross, a professor of economics at a Shanghai university, estimates: “Other things being equal, the direct effects of a 10% increase in the RMB’s (yuan’s) exchange rate would add about 0.26% to world inflation, a 20% increase in the RMB exchange rate would add 0.52% to world inflation.”
Will the combination of a stronger currency and higher wages lead to China becoming an exporter of inflation to the rest of the world? The US import price data needs to be followed closely for signs of a game-changing import of inflation from China.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at email@example.com