Monday, China’s $586 billion dollar stimulus plan appears to have positively reverberated around the world’s stock markets. China’s own indicies were up more than 7 percent, while major indexes in Asia were up 2 to 5 percent on Monday. Even Europe got in on the fun, with its major indexes up 1 to 2 percent. Is the world going Keynesian again, returning to 70s era deficit spending? Will a huge financial spending package in China be enough to mollify stock markets, ending their bear runs?

I am not normally one to attribute rhyme or reason to the movements of stock market indexes. In most cases, only a fool would say how a market is going to move on any given day. Yet today, with the news from China’s central government that it would encourage its domestic market to invest and consume more, it appears to have moved markets in a straight-forward correlation. Certainly, Chinese investors have come to expect the government to step in to prop up stock markets. Last week, it was a rumored $50 billion ‘buffer fund’ that prompted China investors to rally.

US investors are not so easy to impress. The Chinese spending package was not enough to dent the malaise over the US markets, which today were hit by the new of the bankruptcy filing of a major electronics retailer, Circuit City, and layoffs at the US subsidiary of DHL. Finally, the spectre of a slew of possibly negative economic data to be released later this week, including the trade balance, may be prompting caution.

But, back to China, the relatively huge gains in China and other Asian markets indicates, to me at least, that China’s economic news does have the power to help stimulate regional stock markets. But will the package, as China’s leaders claimed, actually help stabilize the world economy? Put another way, can China’s economy save the world’s?

To elaborate on that point, one must not imagine that China will quickly start spending its half trillion dollars to ramp up imports, thereby helping its trading partners. The main effects of this package will be to further push China’s economy toward domestically-fueled expansion via consumption and investment.  It is China’s biggest package ever, the equivalent a $2 trillion package for the US economy, but it will do little to help the world economy, other than encouraging a stable China.

China can afford the package without running a huge deficit, but is there any other cost? Inflation, possibly. One thing is clear, China is most definately now a Keynesian. I hope it can avoid the fate of Japan of the 90s, which tried, and is still trying, to spend its way out of the economic doldrums. Nobody wants to see another lost decade.

The first trading day after the Asia-wide three-day holiday, and following the weekend announcements of Lehman Brothers Chapter 11 filing and the buyout of Merrill Lynch, China’s stock markets dropped in tandem with Asian and world markets.

China Supertrends has been following the financial implications of the sub-prime crisis for a while now and will comment on this latest development and the state of China’s stock markets in a separate post. Today, Tuesday, September 16, was yet another blood-bath in the markets, but at a time like this it is worth remembering that China’s underlying economic fundamentals remain very strong.

In fact, China just came off yet another strong month of growth. If this is true, what causes the apparent contradiction of one of the world’s best performing economies having one of the worst-performing stock markets?

In brief answer to this complex question, let’s just say that the theory of decoupling - the idea that China and other developing countries are mature enough to continue to develop on their own during an economic decline in the US and elsewhere - is increasingly discredited.  We wrote as much in Supertrends: We are living in an inter-connected world, and nothing, not even neo-Mercantilist policies, a protected currency, nor the world’s largest foreign reserves, can resist the forces that are sweeping our world.  As John Donne famously said, no man is an island. This financial crisis calls to all governments to act.

China, with its strong economic performance in August and year-to-date, may appear to be in the eye of the storm, an island of calm and prosperity. Last week was the Mid-Autumn Festival, and the economists at China’s National Bureau of Statistics were producing new data faster than mooncakes at Wang Jia Sha. Virtually everything seems according to plan.

Starting with the drivers of the economy, consumption continued to show signs of strength, with retail sales maintaining a 23.2 percent pace of growth in August, only slightly lower than July’s 23.3 percent, the fastest rate since 1996, according to the Shanghai Daily.

The level of retail sales growth is far above the most recent inflation levels, meaning retail sales growth is not just about price increases, there is real growth there.  In fact, CPI - the consumer price index, or basic inflation - decreased to 4.9 percent in August, continuing the downward trend, but worrisome PPI - the prices producers are paying for raw materials and commodities - continued to climb, to 10.1 percent in August. PPI increases will, at some point, either result in decreased margins and profits as companies absorb the increases, or get passed on to consumers as price increases, so China is not out of inflationary woods yet.

Many were regarding the fight on inflation to be one of China’s core economic policies of 2008, but in a surprise move today the People’s Bank of China decided to cut interest rates by about a quarter percent, down from 7.47 percent to 7.2 percent and, in perhaps the most surprising move of all, cut the reserve ratio by a full one percent after having just increased it by one percent in June.  Now that the Olympics are over, micromanagement of the economy seems back in style.

But the message, that the economy is ready for a rate cut and wants to increase money supply, could be evidence that the PBOC overshot the mark and caused money supply to shrink too quickly, contributing to some of the summer’s abysmal stock and real estate performance.  Growth in M2, the money supply, decreased to 16 percent in August, down from 17.4 percent in June.  It is important to point out here that we are still talking about an increase of 16 percent, just that the rate of speed it was growing simply slowed down a little.

Is the PBOC acting wisely or foolishly? Time will tell if they are cutting too soon, a knee-jerk reaction to the latest sub-prime casualties, trying to prop up the falling stock and property markets, or if they are presciently avoiding a much harder crash in the wake of Fannie/Freddie/Lehman fallout and other factors yet to come.

While some of this data could be construed as negative, China had a lot of other positive economic results in August. For example, the trade surplus is up by 25.7 percent year-to-date, compared with Jan - Aug 2007 figures.

In August, with industrial output growth the lowest in 18 months, a mere 12.8 percent increase, exports decreased to 21.1 percent from 26.9 percent in July. Imports were down more dramatically, from 33.7 to 23.1 percent, mostly because of commodity import price decreases  (i.e. oil), so the trade surplus actually still got bigger. 

Though slowing its rate of increase slightly, clearly China’s export prowess is not affected significantly by the world-wide financial crises, and despite the 2008 increase in  the strength of the RMB exporters seem to have adapted. The sky, it woud seem, is not falling, though its perhaps a paler shade of grey. Ecnomists, analysts, and the Chinese media make a lot of dire proclamations about how the Chinese economy is in decline but this is better thought of as healthier, sustainable growth.

I could go on. FDI and other investments - still strong. Foreign reserve size- still troubling, but thanks to the Fannie Mae / Freddie Mac bailout, the 20 percent of reserves held in US mortgage debt appears safe.

So the question originally posed, why is there a contradiction? China’s strong economy (with all the usual provisos and assumptions about the data, of course) on the one hand, and its weak stock and property markets on the other. What gives?

Is this a sign that global markets cannot decouple and are doomed to falter together, or is it a sign that somebody needs to act more decisively?  Just as China became a stabilizing force in the Asian Financial Crisis of 1997, is there are way it could use its economic and financial strength to do so again?

No country is an island in our globalized world.  Everybody has a stake.  With the alarm bells sounding, can China passively wait for the U.S. to get through its bailouts, and hope that the world financial system remains intact?  Or does this bell ring for another?  Whom does the bell toll for?  China, it tolls for thee.

For those wondering how China would plug the many holes in its supposedly-airtight capital account (allowing a record amount of hot money to flow into China in the past six months), part of the answer was revealed on July 2 via the website of China’s State Administration of Foreign Exchange: A new policy to verify that export invoices are valid and not over-billed for the purposes of transferring more foreign currency into China.

Here at China Supertrends, foreign reserves and hot money are an endless curiosity, having achieved in China never-before-seen volumes, anywhere, in the history of mankind (Perhaps the Romans had a proportionally large foreign reserve, but should that count?).

In a July 3 report from Xinhua, a SAFE official appears to have confirmed the much-speculated figure of US$1.797 trillion in foreign reserves as of the end of May, increasing about US$115 billion in just two months from the last officially-released figure of US$1.682 trillion. From the Xinhua article:

During the first five months of 2008, forex reserves increased by 18.7 percent year-on-year, or US$268.7 billion, SAFE figures showed.

As Brad Setser mentioned recently (and in this older post), there is likely an under-stating of the true amount of the increase in foreign reserves due to internal transfers to the state investment funds Hujin / China Investment Corporation; Chinese banks holding more foreign reserves as the reserve ratio continues to increase (up an additional one percent in June to reach 17.5 percent at present); and revaluations of China’s non-US currency holdings. As well, I’d point out the significant amounts of capital entering the market via the Hong Kong / Shenzhen corridor’s frequent travelers, black market currency traders throughout China, and people such as the Atlantic’s James Fallows withdrawing as much RMB from their foreign bank account as the limits will allow.

Back to the July 2 press release from SAFE, a Financial Times story on July 2 translates some important details:

Exporters will now be required to provide documentary evidence that their invoices are based on genuine transactions if they wish to change dollars into renminbi. The regulator said the new computer system for checking invoices would be introduced on August 4. A trial period begins on July 14.

This is serious news for exporters, and will create additional paperwork and possibly delays for many legitimate transactions. Still, this is what the hot money problem has come to: Reserve ratio increases can soak up liquidity but this is merely treating the symptoms rather than curing the disease.

If the trial proves feasible (and considering the volume of trade, it may not) this will be another problem, in addition to the rise in transportation costs, for China’s exporters (foreign and domestic companies alike) and possibly cause export growth to slow. Not good news for trade, perhaps, but a step in the right direction to reduce hot money.

UPDATE JULY 4: From the Wishful Thinking department, CBS MarketWatch reports SAFE has “limited” foreign tourists to exchanging a maximum of US$50,000 during their stay for the Olympics from July 8 to October 17:

The regulator said the quota would provide tourists with enough spending money while also helping to limit foreign exchange inflows during the games.

With an estimated 500,000 foreign visitors (that’s assuming they can get visas), what’s another US$25 billion of foreign exchange between friends?

Related information:

h/t to China Herald for the excellent Olympic-related news coverage.

An article from Reuters on the foreign exchange issue, relating to the previously-unofficial May 2008 increase.

Shanghai residents and visitors both may recall some of the lively pedestrian malls in the city, the most famous being Nanjing East Road going all the way to the scenic Bund. Shanghai’s Wujiang Road is also famous in the city for serving such delicacies as Shengjian (friend dumplings, most unhealthy but oh so delicious) and fermented tofu (usually served fried) known locally as ’stinky tofu.’ One half of Wujiang Road has undergone a facelift that is indicative of the changing consumer landscape in China.

Retail in China can be a mixed bag: French-retailer Carrefour may be having problems, but China’s Lianhua is doing well, and foreign firms such as Staples and UPS are expanding, even as Bertlesmann China closes its retail outlets.

There are clearly winners and losers, but retail consumption overall is the most important driver of growth in the Chinese economy. The picture is bright, according to a report by AT Kearney that ranks China as the fourth most attractive retail market (h/t to China Law Blog).

Here is my article from the June 30 edition of the Shanghai Star Business Journal, with some before and after pictures for your enjoyment.

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As world energy prices begin to affect transportation costs, the appreciating yuan results in a decreased demand for Chinese exports, and a tighter monetary policy starts to reign in inflation, the question now is how China will avoid a dramatic economic slowdown. If Shanghai’s Wujiang Road area is any indication, retail may be the answer to China’s excess supply, with China’s newly-affluent middle-class consumers increasingly demanding more.

People who have been living in Shanghai for longer than three years will have distinctive memories of the old Wujiang Road, the bustling restaurant street running parallel to Nanjing West Road near the subway station and intersection of Shimen No. 1 Road.

The area directly behind the station used to have Chinese eateries and snack stands, push-cart vendors and colorful events such as a weekly English corner. Now, in much the same way the Huangpu River separates Puxi from Pudong, old from new, Wujiang Road stands divided: East of Shimen No. 1 Road, the street remains much as it has always been, while the western half has recently taken on a new look: Redesigned by Singapore’s Frasers Property and rebranded as InPoint, part of the Jing’An Four Seasons mixed-use residential and retail development, western Wujiang Road is home to a newly-renovated shopping arcade.

The loss of yet another part of Shanghai’s historic past aside, it is hard to deny the new layout and selection is vastly improved.

Where once were about twenty small restaurants and shops now stands a mall with space for more than ninety. Hole-in-the-wall bubble-tea stands have been replaced by four coffee chains including the ubiquitous Starbucks. What once was a Chinese snack vendor selling meihuagao (a rare and delicious baked rice cake with red bean paste inside and topped with dried fruit) is now an Iceason. If you don’t like their ice cream, you can go to one of three other frozen dessert shops, such as a DQ and Cold Stone Creamery, or try Honeymoon Dessert, one of the many Hong Kong and Taiwanese-style snack shops.

Much like the Wujiang Road of old, there are sit-down restaurants galore, but now with a corporate-branded flavor. And that’s not even mentioning the shops: Retailers Levi’s, Tissot, and ONLY, and other sellers of everything from stuffed animals and puzzles to jewelry and baubles.

All this stands in stark contrast to the eastern side of Wujiang Road, with its low-priced stinky tofu vendors, fried dumpling shops, and outdoor crawfish restaurants.

In fact, the transformation of Wujiang Road is not unique, and is merely symbolic of how retail is quickly maturing in China. Shanghai has dozens of revitalized or new shopping areas taking shape, and it seems there is now an international-style mall on every major street to replace what once was a local- or state-owned retailer.

Nationwide, China is home to four of the world’s fifteen largest shopping malls, but many of them, including the world’s biggest in Dongguan, Guangdong Province, are having trouble filling up the space. This begs the retail supply question: If you build it, will they come?

Retail spending has been growing rapidly in China. In 2008, urban retail spending is up 22.3 percent in May year on year, with an average rate of 21.1 percent this year so far compared to the same period last year, according to China’s National Bureau of Statistics. This growth seems likely to exceed 2007’s 17 percent overall increase in retail spending, but this is partly expected due to the increased inflation rate compared to 2007. However, by taking inflation out of the calculation, real retail spending has still grown 13 percent in the first quarter of 2008, according to the World Bank’s most recent China Quarterly Update.

Another important indicator is that in 2007, China’s consumption growth - the portion of GDP growth that covers all the goods and services consumed by households - exceeded the growth due to trade or investment to become the top driver of China’s economy, albeit by a slim margin.

Of course, retail spending is only a part of total consumption, but it is a growing part in China as disposable incomes go up. In 2007, average urban salaries increased 18.7 percent, according to NBS figures, nearly four times the 4.8 percent pace of inflation in 2007, and minimum wage levels were increased in many of China’s largest cities. This excess income will drive new retail spending.

Short-term economic statistics aside, where will the long-term support for retail growth come from? There are three major population segments that will keep retail spending high in China’s cities: The white-collar youth, newly-urbanized migrant populations, and the nouveau riche who are spending on big ticket items in the automotive, housing, and luxury markets.

One study by MasterCard estimates that China will have more than 117 million young people with a yearly income greater than US$60,000 by 2016. A recent survey by website zhaopin.com of 6000 urban Shanghainese white-collar workers found that 80 percent had credit cards, and more than half of them already considered themselves in hock to their cards as monthly “card slaves.” The spending power of more than one hundred million high-income consumers who are comfortable with credit card debt, many of whom will live at home until marriage, will be of growing significance to retail sales.

Second, the urbanization trend in China shows no sign of slowing down. The McKinsey Global Institute estimates China will almost double its urban population to 926 million by 2025, with 219 cities of more than a million inhabitants. Each of these cities will have their own Wujiang Road-style pedestrian malls to stimulate consumers’ taste buds and empty their wallets.

Finally, China’s most affluent people, those who can afford their own cars and homes, are literally driving new trends to support their high-end consumption habits. Cars and homes create much related-goods spending, allowing auto-accessories stores such as Japan’s Autobacs, and home-furnishers such as Ikea, to prosper.

As well, the World Luxury Association reported that in 2007 China became the world’s second largest market for luxury goods such as watches, bags, and jewelry, and will top world leader Japan by 2015.

One only needs to look in a three block radius of the new Wujiang Road to see a healthy microcosm of China’s retail environment: Eastern Wujiang Road for the traditionally-minded, the new InPoint shopping street for young consumers, and Nanjing West Road’s high-end fashion and luxury retailers for the affluent. Some may miss the old meihuagao vendor, but China’s economy is not looking back.

Who wants to be a multi-trillionaire?

Based on the apparent pace of growth in China’s foreign reserves, the State Administration of Foreign Exchange may need to answer this question in a mere three months. Its answer should be an emphatic “Not China.”

In fact, SAFE’s next quarterly announcement of foreign reserves is not due until July but unconfirmed reports have been flying through state and foreign media (covering an unofficial number in China Business News interestingly) that China’s foreign exchange reserves increased by US$74.5 billion in the month of April alone, to reach US$1.76 trillion.

As a point of comparison, the world’s second largest foreign reserves are held by Japan, and in March 2008 they increased by one tenth of China’s apparent April gains - just US$7.6 billion. Incidentally, it was only in February that Japan’s foreign reserves surpassed one trillion for the first time, and they have since fallen back below the trillion mark, once again leaving China the lone member of the trillionaire’s club.

China first hit the one trillion mark way back in November 2006 but, unlike Japan, its foreign reserve increases are usually measured in double-digit billions. If later confirmed by SAFE, April’s increase of US$74.5 billion will be the biggest ever increase, anywhere.

If this pace continues, China’s foreign reserves could reach two trillion as early as August this year.

This is perhaps not the message China’s government wants to send to the world during the Beijing Olympics (”All your money are belong to us”), so there is intense discussion at the highest levels of China’s government over two issues: How to reduce the foreign exchange reserve, and how to use the existing foreign reserves more efficiently.

Reducing China’s Foreign Exchange Reserves

At one time, having enough money on hand to pay for imports might have been a prime consideration, but this has not been the case in China for years. Its current amount of reserves may cover monthly imports 15 times over, or more. What about another main reason countries keep a large foreign exchange reserve on hand, to defend the currency from speculative attack?

China does not allow convertibility of the yuan, which curtails the possibility of a run on the currency, but as well, China, together with the ASEAN countries plus Korea and Japan (the so-called ASEAN + 3), recently pushed forward the Chiang Mai Initiative, a US$80 billion foreign reserve pool that could be swapped to any member country experiencing speculative pressure. In theory, from 2009 this could reduce the need of Asian countries to hold such large foreign reserves. Until then, Asian central banks may feel better safe than sorry and decide to keep more reserves on hand, but China really doesn’t need to do this in the first place, so it needs to more aggressively reduce the size of its foreign currency holdings.

One way to reduce the size of the foreign reserve is to encourage foreign currency outflow. At present, the yuan’s continued and still expected appreciation has actually increased inflows, both as FDI and as hot money, to record levels.

In the first four months of 2008, FDI was up almost 60 percent over the same period last year, while the total number of company registrations actually decreased by 23 percent, according to the Ministry of Commerce. One likely explanation for this is that foreign firms inflated their average investment size so as to benefit from the future yuan appreciation. In fact, for hedge funds and other investors, this is one of the only methods they have to skirt Beijing’s capital controls, sneaking money in as legitimate-seeming FDI. The exact amount of hot money is unclear but can be inferred from known inflows (e.g. announced FDI), the estimated trade surplus, and other data.

To lessen the inward flow of hot money, China could either reduce interest rates to make passive funds less profitable in China, or could revalue the yuan exchange rate in a one-off revaluation similar to 2005 when the original dollar peg was removed. The former is likely to exacerbate China’s current inflation problem, while the latter would shock the country’s exporters. On balance, allowing the yuan to appreciate faster seems the lesser of two evils for the government.

An appreciation will cause outflows for several reasons. Some of the hot money will repatriate, while the stronger Chinese currency will encourage more consumption and imports from abroad. If the trade balance can reverse the current trend of annual surpluses, foreign reserves will dwindle rapidly.

Using the Foreign Reserves more Effectively

The second issue on China’s leaders’ minds is how to use existing reserves more efficiently. Some may even wonder why large foreign reserves are a problem at all. A rich country is a strong country, as this argument goes.

But the foreign reserves are, in effect, sitting in the central bank earning meager returns and keeping the yuan under-valued. Each unit of foreign currency that enters China is bought up by SAFE and yuan notes are issued by the central bank.

China does not actually hold wads and wads of cash, like a high-roller hitting Macau’s new casinos. Most of its funds, especially those denominated in US dollars, are in the form of US Treasury bills and other long term securities. T-bills have a notoriously low interest rate because they are seen as the safest investment available.

With China holding an estimated US$466 billion in T-bills alone according to the US Treasury, earning interest in the low single digits, this means China is literally leaving billions in potential investment income on the table.

Couple this opportunity cost with the depreciation of the US dollar against major world currencies and China’s US dollar holdings are looking even less attractive. Given a common estimate that China’s total foreign reserves are comprised of about 70 percent dollar-denominated securities and cash, and that the depreciation in the US dollar over the last year has been about 10 percent against the yen and 13.5 against the Euro, that is like saying those Chinese reserves in US dollar terms have lost about US$100- 150 billion in spending power.

Of course, China’s Euro and Yen holdings have increased buying power in terms of US dollars, but they only represent about 20 percent and less than 10 percent respectively of China’s foreign reserves. With such low interest returns and the passive depreciation of its US dollar holdings, China is anxious to look for other ways to spend its growing fortune.

In the last six months, SAFE has made a number of portfolio investments abroad in an attempt to diversify and increase returns, while China created the China Investment Corporation, a US$200 billion sovereign wealth fund, in 2007 to place funds in higher-growth areas. [ED: I covered the uses of China's foreign reserves by both SAFE and CIC in an earlier post, The New Gold Mountain.]

At the time of writing, the yuan appreciation has reached 20% against the dollar since that fateful day in 2005 when the peg was finally removed. It has taken three years to get here, and if it takes three more for the next 20%, I worry about the effect this will have on inflation in China as the foreign reserve will continue to surge.

There’s no easy solution to China’s growing problems of inflation and low rate of return on its reserves, but letting the yuan appreciate more quickly is probably the best place to start, for the sake of the Chinese economy, and maybe even the global economy, as a whole.

[UPDATE: June 25 - Two notes which just came to my attention: In regard to how some foreign media have not covered the April 2008 rise of US$75 billion as alarming or even sufficiently surprising, Yves Smith of Naked Capitalism commented yesterday on the apparent nonchalance, and overnight Brad Setser added some data on changes in China's portfolio investments and overall foreign asset growth. On the point of western media attention: I don't think the lack of in-depth coverage on the ramifications is indicative of disinterest. As I pointed out above, the April foreign reserve figure of US$74.5 billion hasn't been officially confirmed and will not be until July, most likely. I held off reporting on this figure in my newspaper column until June 23 expecting a repudiation by SAFE or the PBOC, but their combined silence on this issue has been deafening.]

One of my frequent reads in the econoblogosphere is Brad Setser’s Follow the Money. In a recent post, Setser covered the topic of a June 13 Wall Street Journal article that posits transportation costs from China would affect trade with the US. This in turn was based on a May 27 analyst report from CIBC World Markets provocatively titled “Will Soaring Transportation Costs Reverse Globalization?” Salon’s How the World Works caught this even earlier back in 2006, and updated the post on June 6. I duly covered the topic myself a week ago in in my June 9 Shanghai Star Business Journal column, reprinted below.

But first, Setser raised an interesting question: Why did the WSJ article focus on transportation costs from China when the RMB appreciation has also been significant in 2008?

I would answer this in two ways from a purely practical approach. (I’m going to focus on the US since it is the largest export market for China.)

• China-based firms usually price in US dollars, not RMB, so for much of the appreciation of the past several months, possibly even for all of 2008, suppliers may be locked into existing contracts and pricing schemes, or under frequent pressure from US customers to keep prices steady. This makes the RMB’s rapid appreciation of the past five months less important.
• Transportation costs, on the other hand, are usually set at the time of shipment by a third party (most orders from China may be quoted ex-Factory or FOB to a China port, but rarely priced ‘all-in’ to a foreign port). Therefore, transportation costs for the buyers have been increasing more quickly in the last few months.

As well, there’s probably an economic argument to be made about elasticity of transporation versus a change in price due to exchange rates, but I’ll leave that one alone for now. Instead, here is my article from the June 9 Business Journal:

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China’s Coming Oil Shock

The recent sudden increases in the global price for oil threaten to choke off China’s export economy, further clouding the outlook for what should have been the country’s Olympic year in the sun. June 6 saw the biggest one day price gain ever, exceeding even the period during the two oil shocks in 1973 and 1979, an increase of more than ten dollars in one day. As prices for crude oil continue to climb, closing at an all-time high of US$138 per barrel June 6, China is now facing rising transportation costs that could derail its economic development.

The recent run-up in oil prices was not the first shock China has dealt with in 2008, but the effects of snowstorms, civil unrest and the Sichuan earthquake, already making 2008 one of the most unpredictable in China’s modern development, may be eclipsed by the consequences of a sustained high oil price on China’s economy.

China is not alone: Since the record oil price spike, foreign leaders have been calling on OPEC to increase production. While many analysts believe that the high price is a distortion, possibly due to over-speculation, even a short-term stay at these record prices will cause economic pain for both developed and developing countries. The leaders’ calls echo President Bush who, in March, criticized OPEC for not answering his call to raise output.

At that time, OPEC appeared to be rebuffing Bush for mismanagement of the US economy and US dollar. At present, other global leaders are starting to express worry. Seeking to draw attention to the issue before the upcoming July G8 meeting in Japan, Australia’s Prime Minister Kevin Rudd recently said “We need a clear statement from the world’s major economies to the OPEC producers to lift their production quota now.”

China is caught between a rock and a hard place. It is an export economy relying on its weak currency to fuel exports, while its fuel is made more expensive because of the weak currency. Some analysts say the oil price is set to rise further. Morgan Stanley predicted US$150 oil by July 4, while in May Goldman Sachs forecast US$200 oil within two years before a cutback in demand would cause a return to rational pricing. If this happens, China will be hit with a double body-blow.

First, while China’s currency exchange rate has been set against an unspecified basket of currencies since 2005, when the US dollar peg at 8.28 yuan per dollar was ended, it is still weighted heavily in dollar terms, meaning that as the US dollar depreciates against other major currencies, so does the yuan albeit at a slower pace. With prices for crude set in US dollars, the cost China is paying per barrel steadily increases. This could add further pressure to revalue the yuan at a faster pace.

Second, and this is the real kicker for an export-driven economy such as China’s, transportation costs are going off the charts. Specifically, ocean freight, all those millions of containers being sent from China to the US and Europe, are now significantly more expensive. A May 27 report by CIBC World Markets forecast some major transportation cost increases: If, as Morgan Stanley predicted, oil reaches US$150 per barrel, shipping a container from Shanghai to the eastern US will increase from about US$8,000 today to US$10,000. If the US$200 target from Goldman Sachs is realized, the shipping costs of that same container will rise to US$15,000.

How big of an impact would that have? According to PIERS Global Intelligence Solutions, China shipped the equivalent of 4.65 million 40 foot containers to the US in 2007. This means that, if all those containers were sent to the east coast with oil at US$200 a barrel, the increase from today’s prices in overall shipping costs would top US$32 billion. Suddenly, cheap clothes and knick-knacks for Wal-Mart aren’t so cheap anymore, and the US supply chain would start to shift back to nearby countries such as Mexico.

Of course, China may be expected to produce higher-value exports to negate the effect of transportation costs or to place more emphasis on domestic market consumption rather than on exporting - both of which appear to be happening already - but if the oil prices increase too much too soon, manufacturers could not retool quickly enough. The effect on exporters would be compounded if the high oil price also drives the US further into recession, reducing aggregate demand.

China, the world’s second largest user of oil after the US, can act to alleviate the oil price shock for itself and the global economy by reducing the gasoline subsidy to China’s transportation system as India and Malaysia have recently done. China has some of the cheapest gas in the world among non-petroleum exporting countries, even cheaper than the US currently. This promotes inefficient vehicles and transportation choices. Reducing the subsidy will not only make Chinese industry and transportation more efficient, it will help China meet its own environmental goals and improve quality of life for everyone.

I was getting my regular order at Starbucks in Shanghai the other day, a half-milk Earl Grey Tea with a raisin scone, when it occurred to me that I was paying 50 percent more than just a year ago. I remember this distinctly, because I used to pay 22 yuan (US$3.15) and now I’m paying 33 yuan (US$4.70). Did the price of oil of bergamot spike on world commodity markets? Was there a world-wide shortage of baking powder I didn’t know about?

The tea at Starbucks used to be a deal. You could get any size for the same price and, if I talked to the Chinese baristas nicely, I would even get two tea bags. But now, at 18 yuan for a Grande, 21 yuan for a Venti, or 12 yuan for a micro-sized Small cup, I’m suddenly arguing with them: Hey, aren’t these just tea bags and some hot water?

In fact, virtually everything sold at China’s Starbucks has increased in price since I arrived in Shanghai in 2004. The price of a Venti-sized Caffe Mocha is now 34 yuan which, at recent exchange rates*, is $4.85, as expensive as in Starbucks’ hometown of Seattle. Even my lowly little scone used to be only 8 yuan, now it’s 12. Why the Grande price increases, Starbucks?

The answer, you might suspect, is Starbucks trying to gouge its newly-affluent Chinese white-collar customers, but it’s not that simple of course, and inflation is definitely a contributing factor.

On May 12, China’s National Bureau of Statistics (NBS) announced national inflation, measured by the Consumer Price Index (CPI), had increased by 8.5 percent in April, following a 8.3 percent rise in March and 8 percent overall for the first quarter of 2008. This is, compared to last year’s 4.8 percent inflation (which thereafter became the 2008 target), a significant increase that is starting to look like a trend.

To be sure, Chinese inflation is not all to blame for your Frappuccino price woes: World-wide coffee commodity prices have increased more than 20 percent from a year ago and regularly change depending on agricultural output. Yet Starbucks’ global purchasing clout should be sufficient to insulate it from the yearly price fluctuations. There are also labor, supplies and operating costs to consider. For example, there are the effects of the new Labor Law enacted on January 1st, and producer prices for raw materials, fuel and power have increased about ten percent in the first quarter of 2008, according to the NBS, and the more general Producer Price Index (PPI) increased by 8.1 percent in April.

Are Starbucks’ price increases a sign of a broader pattern? A quick survey found KFC raised prices in March and McDonald’s did so in January and last October. The NBS announced that recent CPI growth is mostly attributed to increases in food prices, which went up 21 percent in the last first quarter. This last figure hit home for me with my monthly home food bills, which my domestic helper (also known as an ayi if you are living in China) aggressively bargains for, yet the amount I reimburse her each month has increased by about 100 percent compared to early 2007.

Some may wonder, what’s the big deal anyway? Isn’t a little inflation good for an economy? General economic principles say yes: In order to keep the economy running smoothly, a little inflation greases the wheels of commerce. This beneficial rate is generally thought to be one or two percent. China’s eight percent is more of an accelerant, but it is hardly hyperinflation, the savings-wrecking triple- or even quadruple-digit rates seen in South American economies such as Bolivia and Argentina in the ’80s. Eight percent is manageable but worrisome things may start to happen.

For example, people could start taking money out of savings, especially if the real interest rate, the bank interest rate minus the inflation rate, is negative, as it is right now in China: The current deposit savings rate mandated by the central bank is 4.14 percent, meaning with inflation at 8 percent, people are losing about 4 percent of their money’s value just by leaving it in the bank. Or, consumers may buy gold as an investment, an start hoarding commodities such as rice or cooking oil, expecting further price increases.

There’s little evidence of massive hoarding of commodities as yet, but in November 2007 three people were killled and 31 injured at a Carrefour Hypermart in Chongqing rushing in to get a 20 percent discount on cooking oil. And when it comes to buying inflation-proof investments, China has a natural love of gold and the China Gold Association said that in 2007 China was the world’s third largest consumer after the United States and India, and 2nd largest producer, in a dead-heat with South Africa. Apparently Olympic gold bars and bullion stamped to commemorate the year of clever (and rich) mouse sold out quickly. 81 percent of gold consumption in China goes into jewelry, which is also a big seller. So what, if anything, to do about increasing prices?

China has several options to combat inflation. Assuming that China’s inflationary dilemma is driven by money supply – that is, China’s huge US$1.68 trillion foreign reserves, hot money, real estate and other asset appreciation – rather than demand (consumption is still relatively low in China at less than 40 percent of the economy), the central bank could increase interest rates or otherwise reduce the supply of money in the economy by tightening bank lending through further increases to the reserve ratio.

The latter tool especially has been overused, increasing ten times in 2007 alone, with the increases each time being very conservative so as not to shock the system. Immediately following the release of the first quarter economic data on the April 16, the People’s Bank of China acted swiftly by raising the reserve requirement ratio, again by 0.5 percent, to a record-high 16 percent. In May, after the April inflation figures were released, they upped the ratio once more. to 16.5 percent. The collective shrug of the market could be seen almost immediately; it is already numb to this kind of pain. Some analysts were predicting a modest half-percent interest-rate increase following the April inflation numbers, but after the devastating earthquake in Sichuan on May 12 the government is likely to be more cautious with further tightening. Thus with only the reserve ratio to cool the economy, and even more fixed asset investment needed after the earthquake, inflation is unlikely to abate in the short-term as the government hopes.

The central bank needs to consider drastic measures and it is time for China to slaughter the sacred cow by allowing faster appreciation of the yuan. Otherwise, your Starbucks soy decaf triple Venti Caramel Macchiato will be getting even more expensive.

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* This article uses 7 yuan per US dollar