Is China set to drive inflation higher?

Cheap labour and goods from China have helped keep inflation across the world low in recent years. But China is now changing its focus from expanding capacity to improving profits, says Martin Spring in the On Target newsletter. Global consumers may find that the cheap goods they've been taking for granted are no longer available - and that means higher inflation.

The Chinese government is embarking on a new course for the nation's economy that is going to catch the unwary by surprise, says consultant Simon Hunt of the eponymous Simon Hunt Strategic Services, in a recent report I've had forwarded to me by a reader.

Past policies drove industrialization at any cost, with key input prices such as land and utility services kept low, and cheap "effectively zero cost" - capital channelled to large enterprises. "What followed was the world's largest-ever fixed asset investment binge." Result: serious over-capacity, bloated inventories and paper-thin profit margins.

A start will be made this year to halt construction of further over-capacity by forcing banks to stop providing extra finance for any except their most creditworthy customers. Manufacturing, especially in the private sector, will be hit hard. Development is to shift away from energy and natural-resource-intensive industries towards services and infotech industries.

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Urban growth, favoured in the past, is to be slowed in favour of development of rural areas, where 57% of people still live. One reason is to address political discontent, with average incomes in cities 3.2 times those in the countryside. Another is to stop loss of agricultural land to urbanization, which on current trends would rob the nation of a quarter of its farming land by 2020.

The national currency will not be allowed to appreciate by more than 2 to 3% a year in US dollar terms. The government wants property prices in Shanghai, which have already eased back 15% - 20% from their peak, to fall another 20% - 25% by the end of next year.

There will be a slowdown, yet real economic growth should still hit 8% this year and 7% in 2007.

Fast-rising costs skilled labour wage rates are going up 30% - 40% a year, unskilled by 10% - 20% are motivating some companies to abandon China for cheaper places. But "once industry has been restructured, say in three to five years, pricing power will return. Profitability will be the motto, not critical mass.

"Then, China will no longer be exporting deflation Global consumers will find that prices for so much of what they buy now will be rising. 2010 may see the start of this period of rising prices for goods like appliances.

"Against that background, it is interesting to note that our friends in Shanghai are very positive on China's stock markets."

By MartinSpring in On Target, a private newsletter on global strategy