We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are

Life, Liberty and the pursuit of Happiness.

That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed,





Thursday, March 23, 2006

The Dragon Could Soon Stumble

China’s not the cheapest anymore. According to William Fung, Managing Director of the US$7 billion Li & Fung Group, rising costs have found their way into prices. Energy costs are higher, but a double-digit rise in labor costs, as well as a stronger yuan, has led to 2% to 3% increase in prices for exports.

Bangladesh, Cambodia and India are expected to benefit from China’s inflation. But this news is potentially much bigger.

A rise in Chinese prices could be disastrous for a company like Wal-Mart, which depends on cheap goods from China to maintain its razor-thin 3.6% profit margins. On the flipside, Latin and South America could become a more attractive manufacturing source. This would be especially good news for countries like Nicaragua where the fledgling democracy is under attack by Hugo Chavez who is spending millions of Venezuelan Oil dollars to instill a communist regime in this years elections. Every "good" job created makes it tougher for the commies to make the charge that capitalism doesn't work.

It could even mean that US manufacturing becomes more competitive. And that would be the best news the trade deficit has heard in years.

Of course, the whole trade deficit thing is a bit of a double-edged sword. If China’s export economy slows due to inflation, it will cut into the countries trade surplus, which will, in turn, affect its purchases of US Treasuries.

If we accept that China’s central bank has had a hand in keeping interest rates low, reduced demand for US bonds could help resolve Greenspan’s conundrum. And rising rates are the market’s biggest fear right now.

Bernanke and the rest of the Fed governors seem content to continue hiking interest rates, even though it may take as long 6 months for rate hikes to work their way into the economy. Throw in a fundamental drag on bond prices, and interest rates could be in for an unexpected spike higher.

US investors have been intensely focused on inflation. It’s as if inflation is the only realistic threat to historically low interest rates. A “back door” catalyst for interest rates, like a slowdown in China’s economy, would undoubtedly take a lot of investors by surprise. The last thing we need to see is a stampede to the exit doors of the bond market.

Over the last six months or so, I’ve talked a lot about the weaknesses of China’s economy, and why the consequences of China’s economic policies could be severe for the world.

China already suffers from overcapacity in many sectors. And a rise in costs will only add to the overcapacity problem. Because I highly doubt that China’s central planners will allow massive layoffs if/when the economy slows.

That, in turn, will only raise the odds that China will start dumping its surplus on the global marketplace.

Or suppose China does take the free-market route and let workers get laid off? Demand falls, commodity prices across the board fall (including oil) and the emerging market miracle we’ve seen abruptly ends. Think about the crushing blow to all the oil dictators who have been banking on $60 per barrel oil from now to the future.

Then, not only do rates rise on emerging market debt, the financial markets lose a strong source of support in petrodollars.

Greenspan often talked about how derivatives and globalization have spread risk around the globe. That’s usually taken as a good thing. But it also exposes a deep dependency.

A slowdown in China’s economy could be destabilizing for every economy in the world. The US would however be best positioned to deal with this without a major recession.

We'll wait and see, but watch your international holdings if you've moved a substantial amount of money into them in search of higher returns.

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