China's newest export: Inflation

But costs are now rising in China. At China's Shougang Group, for example, the cost of producing auto parts climbed by 59% in 2007.

The price pressure on automakers is coming from all directions. The cost of raw materials is soaring. Iron ore prices were up 65% in 2007, and domestic steel prices climbed 35%. In February 2008, Baosteel Group, China's largest steel supplier, raised the price of the cold-rolled steel used for auto-body parts by 17%. Wages are climbing. Labor costs in the most industrialized parts of southeastern China have climbed 50% in the last four years. Logistics and freight costs are up. Companies that have moved to remote parts of China in an effort to find cheaper labor have seen increased costs in getting goods to market over China's sometimes inefficient transportation network.

China is also paying the price of inefficiencies in the global transportation system as demand for shipping has resulted in historic highs for bulk carriers and container vessels.

What's driving the change

Two basic and related trends in the Chinese economy are behind all those pressures. First, the decision of the Beijing government to hold down appreciation in the yuan in order to protect Chinese exports has resulted in a runaway expansion of the money supply. Yes, the yuan has climbed in value against the U.S. dollar by about 20% in three years, but the currency is still extremely undervalued.

To limit the rise in the yuan, which makes Chinese products more expensive to overseas customers, the Chinese central bank has had to buy dollars, but that has had the effect of putting more yuan into circulation. In April, China's money supply grew 16.3%. That's an improvement from April's 17.5% annualized growth but still more than enough to stoke inflation. Inflation in consumer prices hit an annualized 8.5% in April. That's the third straight month with inflation above 8%.

Second, inflation now has its own momentum in China. Workers -- in short supply in many of China's most industrialized areas -- are demanding that wages keep up with inflation and then some. The minimum wage in Shanghai, for example, which went up by 12% in September 2007, climbed an additional 14% in April.

Chinese companies that had eaten these higher costs rather than pass them on to their customers are finally throwing in the towel. Chinese makers of air conditioners, refrigerators and washing machines had not raised prices despite the climb in the cost of steel, but they're now scrambling to see who will raise prices -- and lose market share -- and who will hold prices steady -- and lose profits. So far it looks like white-goods giant Haier Group has beaten back efforts to raise prices for air conditioners but is leading the way with a 5% to 10% increase in the prices of washing machines and refrigerators.

The three largest contract manufacturers of laptop computers -- Taiwan's Quanta Computer, Compal Electronics and Wistron -- have finally brought such customers as Hewlett-Packard (HPQ, news, msgs) and Dell (DELL, news, msgs) to the bargaining table over price increases. Over the past few years those big customers had forced the contract manufacturers to eat rising labor, plastic, copper and component costs at their mainland Chinese factories.

But in May the manufacturers hit the wall. Labor costs in China are up 25%, the manufacturers say, and consumers are just going to have to pay part of that in higher prices for laptop computers.

Because Chinese companies have been so reluctant to raise prices, corporate and individual consumers in the U.S. have only started to see China's newest export, inflation, in the prices they pay in stores. But the effect, while small, is visible. In 2007 the prices of Chinese exports to the U.S. rose 2.4% from 2006. Not very much considering the rise of the yuan against the dollar -- but earthshaking when you consider that the prices of Chinese goods imported into the U.S. have been falling year by year even as the dollar slumped against the Chinese currency.

Higher prices for US consumers

The numbers show us shifting from a period when the constantly falling prices of Chinese import prices were subtracted from U.S. inflation to a time when rising prices of Chinese imports adds to U.S. inflation. With the Federal Reserve already worried that U.S. inflation is too high, the shift couldn't come at a worse time.

And the rising prices of Chinese imports won't help struggling U.S. consumers either. Chinese imports account for just 8% of consumer spending in the U.S., but those imports are disproportionately represented in categories such as toys (80%), shoes (85%) and clothing (40%). The toy industry, for example, projects 5% to 10% price increases by Christmas.

And any price increase on Chinese imports will also hit disproportionately hard at big-box stores such as Wal-Mart. About 70% of the products that Wal-Mart sells come from China.

None of this is exactly good news. U.S. consumers already strapped by the rising costs of gasoline and food don't need to see price increases at Wal-Mart and Costco Wholesale (COST, news, msgs) for clothes, shoes and toys. And the U.S. economy is struggling with its own inflationary burden: Consumer prices climbed at an annual rate of almost 4% in April, if you believe the official numbers.

The Federal Reserve would love to see that number fall back below 3%. The bankers hope a slowing U.S. economy will do the trick by itself, without the central bank raising interest rates. Any increase in rates, of course, raises the odds that the U.S. economy will slip further toward recession and that a new crisis will erupt in the financial markets.

Any gradual increase in inflation caused by China's newest export will make the challenge facing the Federal Reserve just that much tougher.

Continued: An update and developments

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