China's Engine Still Pulls the World

04/01/2010 2:37 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Growth in China isn’t slowing down—at least the manufacturing sector isn’t. The Purchasing Managers’ Index climbed to 55.1 in March from 52 in February, Li Fung Group reported today (April 1).

So far, Beijing’s attempts to rein in growth by raising reserve requirements for banks and setting lower quotas for loans isn’t having any noticeable effect on the sector.

At this time, strong growth in China is a two-edged sword, however.

On the plus side, strong growth from China is good for the global economy. According to the International Monetary Fund (IMF), the global economy will grow by 3.9% in 2010. That’s up from a decline of 0.8% in 2009.

China is clearly the engine that’s getting the train rolling. The IMF forecasts that China’s economy will grow by 10% in 2010. The US economy, the IMF forecast in January, will grow at just better than 2% this year, and the economy of the European Union will grow by just 1%.

So, Thursday morning’s news about an acceleration in growth for China’s manufacturing sector drove up the stocks of global commodity producers and global exporters.

But China is fighting a battle to prevent inflation (which came in at a distressingly high 2.7% in February) from moving even higher. Prices at the wholesale level have been rising at an even faster rate—5.4% in February. (For more on the danger of higher inflation in China, see this recent post.)

This inflation battle is the other edge of the sword. If growth in China doesn’t slow as a result of current government efforts and inflation threatens to move higher—and indeed, to escape control—then the government will take further steps such as actually raising interest rates charged to banks, cutting lending targets further, and maybe even—finally—allowing the renminbi to appreciate against the dollar.

The Chinese government has been extremely reluctant to end the renminbi/dollar peg that it put in place to protect Chinese exporters during the global economic slowdown. At that point, the dollar was a declining currency, so that the peg made Chinese exports cheaper against competitors from the rest of Asia and Europe.

But the huge inflows of currency that come along with roaring growth in the export sector make inflation harder to control, and an undervalued renminbi makes imports more expensive to Chinese consumers, which also adds to inflation.

And, of course, speculation that Beijing will revalue the renminbi has led to hot money flowing into China in an attempt to profit from that appreciation in the currency, whenever it should come.

Where does all this leave investors?

Still bouncing around between hope that China's growth will drive the global economy and demand for commodities and fear that China's government will be forced to take stronger steps to slow the economy in order to fight inflation.

Until that is resolved—until inflation is clearly under control—I'd expect China's stocks and the shares of the companies that depend on China's growth to bounce around without a strong trend lasting more than a few weeks.

Full disclosure: I don't own shares of any company mentioned in this post.

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