As long as China can improve efficiency, it won't have to raise prices. But a recent Reuters article suggests that this notion is wishful thinking. The article notes that efficiency at China's listed manufacturing companies peaked last year and has already started to deteriorate, meaning that China could soon start passing on higher costs. Recent industry surveys confirm this idea. According to Global Sources, the Hong Kong trading company, 80% of 709 Chinese exporters surveyed late last year said they expected to increase prices within six months of the survey.

Some commentators point out that Chinese export prices remain steady when expressed in yuan terms, but export prices turn higher when expressed in dollars. As the Economist added: “It is the weak dollar, not cantering cost inflation in China, that is to blame for higher American import prices. China’s manufacturing costs and exports prices in yuan terms are still falling overall.” (August 2, 2007) Although a weaker dollar should lead to inflation, the relationship is not that simple. According to a recent Wall Street Journal article, there is evidence to suggest that foreign exporters are willing to adjust prices to hold on to U.S. market share as the dollar declines in value. This is especially true when the U.S. economy is slowing and consumers are less willing to pay higher prices. The implication here is that Chinese manufacturers might be hesitant to pass on higher input costs, for fear of losing U.S. market share.

There are also geopolitical shifts to consider. If China fails to increase efficiency to cope with higher input costs, these costs might be passed on to consumers worldwide, and China's competitive advantage might begin to diminish faster than experts thought. Such a development may raise doubts about China's long-term ability to conquer the world.

But if we are to discuss China's long-term ability to conquer the world, it is important to differentiate between short-term and long-term effects. Even if China's rising input costs are passed on in the short-term (next 2 years), the structural changes in China's manufacturing might have a deflationary impact in the longer term. Standard Chartered economist Gerard Lyons says that China's move into more valuable manufactured goods such as automobiles will, in years to come, have the same deflationary effects on world markets as the country's push into low-end manufacturing. Such a development might maintain China's competitive advantage.

In summary, China will probably start passing on higher costs in the short-term, but it's too soon to jump to a conclusion that this change will be permanent. There is still room for China to improve efficiency over the next decade. A survey carried out in September by the People's Bank of China showed that the technological capacity of Chinese enterprises was relatively low compared with foreign counterparts and that companies still had potential to raise efficiency. As long as China improves efficiency in the next decade, a necessary condition for its exports to remain competitive despite rising input costs, the country may continue to be a source of deflation.

Disclaimer: I have no exposure to China

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China  Currency  Eben Esterhuizen  Opinions 

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