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Rein: US Downgrade to Worsen China's Inflation Problem

Chinese policymakers spent an uneasy weekend determining how to deal with the S&P’s downgrade of America's debt. S&P’s decision risks eroding the value of China’s estimated $1.16 trillion in Treasury securities, especially if investors begin demanding a higher risk premium for owning U.S. government bonds. Already frustrated by the plummeting dollar, China blasted America after the downgrade.

Citizens purchase goods at a supermarket in Beijing, China.
Chinafotopress | Getty Images AsiaPac
Citizens purchase goods at a supermarket in Beijing, China.

Xinhua news agency, the official mouthpiece of the central government, lashed out: "The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone." It continued by saying America needs to end its addiction to debt by curtailing its military expenditures and social welfare programs.

One influential player in Chinese policy-making circles echoed Xinhua’s views and exasperatedly told me, “The American Congress has become so irresponsible with all its bickering. Their disgusting politics is hurting the rest of the world. America has essentially abdicated its responsibility as financial leader. It really is shocking.” China’s central bank governor Zhou Xiaochuan criticized the United States too and announced China will continue to diversify away from Treasury Bills.

The downgrade will have a far more serious affect on China than just eroding the value of its reserves, but there are no easy solutions. The most serious problem in the short term is inflation, which will get worse as investors shift away from U.S. dollars and into commodities. On Monday there was a selloff in commodities, but in the long term if the dollar continues to fall commodity prices will rise. The downgrade also increases the possibility of another round of quantitative easing in the U.S., which is negative for the dollar and will heighten inflation.

Inflation has already been running rampant in China as rising labor and real estate costs combined with soaring global commodity prices have been a double whammy for the economy.

Inflation officially hit 6.4 percent in June, a three-year high, but it feels much higher for everyday Chinese because food costs have soared 10 to 15 percent. Yoghurt prices have gone up 25 percent in the first half of the year and home prices in most of the country have risen by double digit percentage points in 2011 despite tighter policies on mortgages. Thirteen Chinese provinces raised their minimum wages by over 20 percent in the first half of the year.

To combat rising labor costs, Foxconn, the maker of many Appleproducts, announced it was increasing the number of its robots on production lines from 10,000 to over one million in the next few years to replace human labor. McDonald’s and Starbucks have both increased prices. Other companies like Pepsi and Coca-Cola have shrunk can sizes from 600 ml to 500 ml.

The pain is being felt by everyday Chinese. Last week taxi drivers in Hangzhou protested rising gasoline prices for several days.

Investors should not underestimate the inflationary pressures hitting China. Aside from protesting taxi drivers, the manufacturing sector is feeling the pain. Thousands of factories already have shut. One factory owner who makes fashion accessories in Wenzhou, told me, he would have to shut his factories unless raw material prices drop significantly in the next quarter because he cannot yet transfer prices to his end customers.

Policy makers in Beijing have to walk a fine line between trying to stop inflation through cooling measures such as hiking interest rates and reserve ratios for banks and not putting the brakes on too fast. Already U.S. foreign direct investment in China has dropped over 25 percent in the first-half of the year. Many of the factory closures have been healthy for the economy as the country shifts away from high polluting manufacturing to services but too many more will disrupt the domestic economy.

The bickering by America’s political class is having grave affects on China and the rest of the world. The damage to America’s standing in the eyes of the rest of the world has been far worse because of the perception that the world’s financial system has been hijacked by members of Congress who put political campaigning ahead of reason.

Shaun Rein is the founder and managing director of the China Market Research Group (www.cmrconsulting.com.cn) a strategic market intelligence firm, and is based in Shanghai. He is the author of the upcoming book “The End of Cheap China: Economic and Cultural Trends that will Disrupt the World” published by John Wiley & Sons in the US. He does not own shares in any company mentioned. Follow him on Twitter at @shaunrein.