Watch for the new export from China: inflation

By Wei Gu

HONG KONG (Reuters) - U.S. politicians may soon regret what they have been wishing for.

Having long accused Beijing of manipulating its currency to keep Chinese exports inexpensive, thus gaining an unfair trade advantage, Americans might find a new troublesome export from China: inflation.

Due to the combined gains in the Chinese yuan -- up 3 percent against the U.S. dollar in the last two months -- as well as food, energy and other raw material price rises that have pushed domestic inflation to 11 year highs, China's manufacturing sector can no longer offset rising prices with productivity gains.

Efficiency at China's listed manufacturing companies peaked last year and has already started to deteriorate. On top of that, Beijing is considering letting land and other resource prices rise to market levels, while a more stringent labor law that took affect this week will surely push up labor costs.

The question is, will China be able to pass on higher costs to global consumers?

"China's export prices were rising in the last quarter even though U.S. import prices have slowed," said Paul Cavey, head of China economics at Macquarie Securities. "That does suggest that China does have a bit of pricing power."

What a change from the past five years. During that period China was a deflationary force, helping keep global prices low.

To be sure, Chinese exports to the United States are still slightly cheaper than they were in 2003, according to U.S. government figures. But the trend is clear. Prices have started to climb in the past year, and increases are likely to accelerate in 2008.

This should not come as a big surprise, since China cannot push the productivity envelope forever. Eventually, the law of diminishing returns will prevail. When inflation hits a country that is a global factory, the rest of the world will have to pay more.

"When China starts to export inflation, it will feed through the rest of the world," notes Dong Tao, an economist at Credit Suisse.

UNFORTUNATE TIMING

Hong Kong, which gets most of its grocery and electricity from the mainland, is already feeling the heat. From food to furniture, and wages to rent, almost everything is going up in the city. To add fuel to the fire, Hong Kong has to follow the U.S. Fed to pump more liquidity into the system because its currency is pegged to the U.S. dollar.

As a result, Tao expects Hong Kong inflation to average a surprising 5.1 percent in 2008, while most other analysts sees inflation closer to 3.3 percent.

Western consumers will see prices jump for electronics, clothing and toys, although these gains will be masked slightly since manufactured goods account for a relatively small part of the consumer price index (CPI) baskets in the United States and European Union.

Barring any policy mishaps, China's exported inflation shouldn't rock those economies, although it comes at an inopportune time when the U.S. is battling a slowing economy, $100 oil, and a still-unfolding credit crisis.