Inflation: China's Newest Export

04/06/2011 4:06 pm EST

Focus: MARKETS

Robert Hsu

Editor, China Strategy and Asia Edge

It’s only a matter of time until the inflation already seen in Asia and Europe hits these shores, writes Robert Hsu, editor of China Strategy.

I've recently been planning trips to China and Europe, and I was shocked at just how much prices have surged compared with last year. Airfare, hotel, and car service prices—all are higher than when I booked my trips last year.

For example, the cost of hotel rooms and other services in Shanghai is up more than 50% just in the past two years, on par with New York City. Prices have gone up considerably throughout Europe as well. It is often less expensive to buy Italian suits, Swiss watches, and German cars in Los Angeles than their respective countries of origin.

Compared with Europe and Asia, the US is right now the best country for good deals. But even in America, currently one of the best locations for consumers to go shopping, prices will not stay low forever.

Inflation is making a comeback in the US, and there are three big reasons why it will accelerate in the coming months:

1. Weak US Dollar
The dollar has lost ground against every major currency in the past 12 months. Even with the European debt crisis of the past year, the Euro is now higher against the dollar than the pre-crisis level. The dollar has also lost between 4% and 12% against various Asian currencies during the past year.

The greenback is gradually losing its traditional status as a safe haven and global reserve currency. In the ongoing Middle East unrest, flight capital from the region poured into the Swiss franc (FXF) instead of the US dollar, the traditional safe haven, driving the franc up to an all-time high.

In addition, the Fed under "Helicopter" Ben Bernanke is determined to reflate the economy by flooding the world with dollars. This will further devalue the worth of our paper money.

2. High Commodity Prices
With oil prices above $100 again, high commodity prices are back in the spotlight. Yet many commodities—such as gold (GLD), silver (SLV), copper (JJC), and cotton (BAL), just to name a few—are already much higher than they were before the global financial crisis.

For instance, both gold and copper are already 50% higher than they were three years ago. Higher commodity prices lead to high raw-material prices, which is a significant component of final goods prices.

Some investors may think that a falling US dollar and surging commodity prices are nothing new. After all, except for housing prices, we saw these same trends play out from 2004 to 2008 without a major impact on consumer inflation.

But it is different this time—because of China.

NEXT: 3. The China Factor

|pagebreak|

3. The China Factor
During the 2004-2008 commodities bull market, then-Federal Reserve Chairman Alan Greenspan's easy monetary policy generated a US-led global bull market in stocks and commodities. Growing US consumption—in tandem with the housing boom—spearheaded the global surge higher, driving the outsourcing of manufacturing to China.

However, despite rising commodity prices, China's cheap labor cost managed to offset much of the inflationary pressure created by declining US dollar and high commodity prices.

Back then, China managed to export deflation to offset higher commodity prices and keep US prices in check. Also, much of the excess capital went into the US housing sector.

After the global financial crisis, China and other Asian countries pumped massive liquidity into their economies, allowing these countries to recover much faster than the US and Europe. Although Bernanke tries to reflate the US economy, changes in the US financial-services industry has made it more difficult to do so now than in the Greenspan era.

With the creation of massive liquidity, China has experienced higher inflation as well, the impact of which is largely offset with wage hikes. Labor cost in Chinese coastal cities surged more than 40% in US dollar terms during the past two years.

Companies involved in Chinese domestic consumption, such as China Strategy recommendations China Kanghui (KH), Country Style Cooking (CCSC), Ctrip.com (CTRP), Louis Vuitton Moet Hennessy (OTC: LVMUY), NetEase.com (NTES), and Starbucks (SBUX), welcome these wage hikes, as consumers will have more money to buy their goods and services.

Even though the US financial-services industry is less efficient now in pumping liquidity into our economy, the Fed will still eventually have its way. But this time around, China is actually exporting inflation instead of deflation.

With the combination of the Fed endlessly pumping cheap dollars, higher raw material prices and higher costs in China, inflation is starting to surge in America as well.

So even as inflation starts to come under control in China, things are just beginning to pick up here. During times of inflation, the textbook investment strategy is to increase debt, invest, and then repay the debt with devalued money.

Subscribe to China Strategy here...

Related Reading:

Related Articles on MARKETS