Why China may soon ditch its biggest export - deflation

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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.

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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)

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.

Turning to the wider markets...

The FTSE 100 ended 36 points higher at 5,706. Online poker group PartyGaming was the main faller, down 4% to 117.75p, as the company's founders sold 5% of the firm at the knock-down price of 116p a share. Miners also continued to fall, as metal prices slid for the third day in a row. For a full market report, see: London market close

Over in continental Europe, the Paris Cac 40 gained 26 points to 4,824, while the German Dax rose 41 to close at 5,543.

Across the Atlantic, stocks fell further, as fears over inflation continue to worry investors. As if that wasn't enough to be concerned about, US economic growth is also set to slow by more than expected in the second half, according to the half-yearly Philadelphia Federal Reserve survey. The Dow Jones Industrial Average fell 71 points to 10,930, the first time it has closed below 11,000 since March. The S&P 500 fell 7 points to 1,256 and the tech-heavy Nasdaq shed 10 to 2,151, its lowest close since November last year.

Fear of a US slowdown took its toll on Asian markets too. The Nikkei 225 fell 462 points to 14,633, the worst single-day fall since April 2005, and the first time it has closed below 15,000 since November. Exporters such as car maker Toyota and digital camera group Canon led the fallers.

This morning, oil was easing back in New York, trading at around $70.10 a barrel. Brent crude was also lower, trading at around $67.

Meanwhile, spot gold was lower, falling as far as $616.40 an ounce, before heading higher to trade at around $623. The strengthening dollar was behind the fall - the greenback hit a one-month high against the yen as investors revise up their interest rate expectations. Silver traded at around $11.73 an ounce.

And later today in the UK, the Bank of England will announce its latest decision on interest rates. The base rate is very likely to remain at 4.5%, but minutes from last month's meeting showed that the Bank is increasingly swaying towards a rate hike.

And our two recommended articles for today...

Why are global stock markets in turmoil?

- A correction of around 10% is thought healthy in a long-term bull market - but more extensive falls usually signal that something is badly wrong, says Jeremy Batstone of Charles Stanley. So what are the reasons behind the current turmoil in equity markets? And was May's volatility just a blip, or are markets at a turning point? To find out, click here: Why are global stock markets in turmoil?

The best way to profit from the gold bull

- The gold price has fallen sharply in the past month. This is just a healthy correction in a long term bull market, say Andrew Selsby and John Robson of RH Asset Management. The dollar's days are numbered, and that's good news for the yellow metal. But one asset class will beat even gold - to find out what it is, click here: The best way to profit from the gold bull