Ambrose Evans-Pritchard: As 'China effect' reverses, inflation threatens

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By Ambrose Evans-Pritchard
The Telegraph, London
Saturday, July 7, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/07/cninfl...

When the prime minister appears on television vowing to "get to grips with inflation," you know that a serious problem is taking shape.

Gordon Brown had the good fortune to be chancellor over a golden decade as the industrial revolutions of China, India, and emerging Asia supplied us ever cheaper manufactures.

In this miracle world, we have had 5 percent global growth for five years -- the best since the Second World War -- without overheating.

Known broadly as the "China effect," it has held down goods inflation. The rich West has been able to indulge in housing booms and credit sprees without an ugly knock-on into consumer price index inflation.

The game is now up.

Industrial wages on China's eastern seaboard have jumped 50 percent over two years, while salaries in Bangalore have risen so much that software companies are outsourcing back to Europe.

Michael Saunders, an economist at Citigroup, said the era of imported disinflation is over. "We're no longer getting cheap goods from Asia. At the same time, growing demand from these countries is pushing up commodity prices across the board," he said.

Lead prices have jumped to $2,900 a tonne (L1,440), up 160 percent since last summer, on battery demand for the booming car industries of China and India.

Brent oil reached $75.10 a barrel yesterday, just $5 shy of its all-time high last year. The oil surge is in turn driving demand for bio-fuels, crowding out the grain market.

Corn prices are up 60 percent in a year and are now flirting with $4 a bushel. As farmers switch acres to exploit the ethanol boom, other grains are being displaced. Looming shortages have now driven up soybean prices 50 percent since October. Grain inflation has in turn raised the cost of animal feed.

China, Russia, and the petrodollar states of the Middle East "hoarded" much of their new wealth in the early phase of this boom, preferring to build vast rainy-day funds and buy global bonds. Now some of them are starting to let rip on spending.

Fresh data from the International Monetary Fund shows a clear change in trade patterns over the past year as Middle Eastern, Asian, and Latin American countries go on a global shopping spree. Put another way, they are giving the world economy a "demand shock." Less bonds: more BMWs, yachts, private aircraft, flat-screen TVs, fine wine, and English furniture.

The oil exporters alone earn annual revenues of $1,250 billion. No longer fearing that the energy boom might fizzle as it did in the early 1980s, they are switching from saving to imports -- perhaps unwisely.

As for China, it has learned that accumulating world record reserves of $1.3 trillion to hold down the yuan is playing havoc with monetary policy and causing inflationary "blowback" at home. Chinese inflation has crept up to 3.4 percent and threatens to break out. This game too is up.

There is now a whiff of the late-1960s in the air as benign boom turns to a faintly menacing, late-cycle nexus of excesses. Rampant global liquidity has driven up asset prices. This inevitably spills over into ordinary inflation, albeit with a time lag.

Where is it coming from?

Roughly $500 billion has leaked out of Japan through the "yen carry trade," the side-effect of Tokyo's long battle to stave off a deflationary slump through zero interest rates (now 0.5 percent). Above all, $5.4 trillion of foreign currency reserves built up by world central banks is being recycled into the global bond markets, causing a credit bubble. In a sense this great stash of wealth is the driving force behind the leveraged buyout boom and junk bond bubble.

Ultimately, however, it is the US Federal Reserve, the European Central Bank, and other big guns of the G7 that really run the world monetary system. The jury is out on whether these banks kept the spigot of cheap credit open for too long.

Rates in America were 1 percent until June 2004, when the economy was already growing at 5 percent -- a break with orthodoxy. The ECB kept euro-rates at 2 percent until December 2005, even though the M3 money supply was already rising at twice the 4.5 percent target (now 10.7 percent) and property prices were rocketing in Spain, Ireland, and Holland.

We are now at the very delicate point where inflated house and asset prices threaten to infect everything, setting off a wage-price spiral.

The central banks have belatedly jammed on the brakes: 17 rate rises to 5.25 percent in the US, and eight rises to 4 percent in Europe. Here in Britain, the Bank of England is on the warpath, raising this week to 5.75 percent.

It takes a couple of years for the full effects of monetary policy to feed through, so we will find out in 2008 and beyond whether these hyperactive banks have swung in time-honoured fashion from underkill to overkill. Or, indeed, whether they left it too late.

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