June 26, 2008 / 6:22 PM / 11 years ago

Inflation has firms rethinking Made in China

WASHINGTON/NEW YORK (Reuters) - From southeast China to the California ports, a seemingly endless fleet of container ships has carried more and more cut-price merchandise to bargain-hungry U.S. consumers.

But the flow is now slowing as soaring costs for food, fuel and a host of other raw materials drive up prices inside China, making its exports more expensive too.

The result is higher prices at U.S. stores like Wal-Mart and Target that have increasingly filled their shelves with Chinese-made goods. It may also mean thinner profit margins for a wide swathe of Corporate America, which for years looked to China to drive down costs. And it is beginning to spur a global treasure hunt for the world’s next low-cost factory.

The price pressure comes at a delicate time for a U.S. economy still limping through a housing slump now in its third year. Homeowners are feeling poorer, and that has cut into consumer spending, making it harder for companies to raise prices to keep up with inflation.

“It has been China that held down (U.S.) inflation, and I think that’s what we’re going to lose,” said Jerry Hausman, an economics professor at the Massachusetts Institute of Technology who has studied Wal-Mart’s impact on inflation.

“Not only is China exporting inflation, but China ... is a reason for a lot of the commodities inflation. They’re both cause and effect of the inflation,” he said.

As China’s fast-growing economy gobbles up a greater portion of the world’s resources, pushing up inflation, its export machine is starting to choke on the higher prices. The rest of the world is feeling the pressure as well, most acutely in poor countries that are struggling to feed their populations as food costs climb.

Wages for China’s factory workers are rising sharply. Some 50 nations, representing 42 percent of the world’s population, currently have inflation rising at double-digit rates, according to Morgan Stanley research.

That helps explain why U.S. import prices posted their biggest three-month rise since 1990 through May. The cost of imports from China were up 4.6 percent for the year ended in May, the largest annual increase since that index was first published in December 2003.

The end result is that each U.S. dollar buys less than it did last year. U.S. Labor Department data shows that it now takes $104.48 to deliver the same buying power as $100 last year. From 2006 to 2007, that change was a more modest $2.85.

THE WAL-MART EFFECT

The China connection is perhaps most visible inside the largest U.S. retail chains. Wal-Mart Stores Inc (WMT.N), Target Corp (TGT.N) and other mega-stores have ramped up imports from China over the past decade, one of their sharpest weapons in the battle for the lowest prices.

Imports now account for nearly 18 percent of the U.S. aggregate demand, up from 10 percent in the late 1980s, U.S. Federal Reserve Vice Chairman Donald Kohn said on Thursday.

The reason is simply price.

In 1997, a dozen men’s shirts cost retailers on average $59.15, according to U.S. Commerce Department data analyzed by Sanford Bernstein & Co. In 2007, they cost $42.14. The rise of China as an exporting powerhouse was a big reason behind that fall in retailers’ costs.

But more recent data shows prices are rising inside the stores that have long prided themselves on lowering prices.

JPMorgan analysts conduct a monthly pricing survey at chains including Wal-Mart and Target. In May 2007, a basket of 23 identical goods cost $106.92 at Wal-Mart and $110.21 at Target. In May 2008, those same goods cost $108.79 at Wal-Mart, and $111.93 at Target.

Lena Michaud, a spokeswoman for Minneapolis-based Target, said the retailer was starting to see inflation on clothing and housewares it is buying for the second half of the year.

“In all cases, we will attempt to maintain our gross margin rate on affected items but of course the outcome depends on the market’s response to any cost increases,” she said.

Uta Werner, retail sector analyst with Sanford Bernstein, said retailers were searching for other regions to replace China, but their profit margins would likely take a modest hit in the meantime.

MADE IN VIETNAM

Replacing China as the factory to the world is a tall order. With the exception of India, no country can come close to China’s population of potential factory workers, but India lacks the infrastructure to quickly step in.

Still, there are signs that companies are shifting at least some manufacturing elsewhere. Vietnam and Mexico are two of the hottest locales.

Chris Kuehl, chief economist at the Fabricators and Manufacturers Association, said his members were fielding calls from customers looking into moving production to Mexico from China.

“It’s still a trickle compared to what it was in the past (before the rise of China), but they keep getting inquiries from people who are saying, ‘We’re thinking of moving operations back to North America,’” he said.

While moving closer to home cuts the shipping costs — a key factor when oil prices are at a record high — companies cannot escape inflation just by leaving China. Mexico’s central bank recently raised interest rates to try to cap price rises.

“The more recent inflation coming from oil and food price pressures is a global phenomenon and is likely to affect all prices,” said Emek Basker, a professor at the University of Missouri in Columbia, Missouri, who has studied said import patterns among large retailers including Wal-Mart.

“Most stores will have to raise prices in response to these higher costs.”

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