DALIAN, China: China's money

China has turned decisively from being a deflationary to an inflationary factor in the world economy.

Just as the falling cost of manufactured goods driven by China enabled the industrialized world to enjoy nearly stable consumer prices despite very loose monetary policies, so now the reverse is beginning to happen. Loose money has taken a grip on China and its effects will feed back to the West.

It is easy to dismiss China's reports of a 6.5 percent surge in consumer prices over the past year as a passing problem caused primarily by shoddy exported goods and the scare over tainted food - particularly the highly infectious swine virus sweeping China's pig population, driving up pork prices.

But there are an increasing number of Chinese economists who do not share the comfortable illusion propagated by several foreign investment banks that these problems are just a passing problem and that "core" inflation remains close to the government's upper limit goal of 3 percent.

In a low-income country such as China, food occupies a very large part of the consumer price index. Moreover, for a government already worried about the political implications of a seemingly ever-growing income gap, lower-income urban workers are the hardest hit by rising food prices. There is little benefit for them in the fact that prices of cars and gasoline have fallen slightly.

As a result, sharp increases in food prices are leading to pressure for faster wage increases at a time when there are signs that productivity is slowing after several years of rapid growth.

Nor can one be sure that the rise in food prices is a one-time event, given that global prices for many food items have been rising as well. There is also political pressure within China to welcome higher food prices as a way of reducing the urban-rural income imbalance, which is at the root of ills ranging from abysmal rural health and educational services to periodic civil disturbances.

The prices of other commodities have remained stable, enabling Chinese manufacturers to hold prices down, thanks to the negligible cost of capital and the apparently easy profits from property development and stock market investments. These profits have been fueled in turn by rapid growth in the money supply as interest rates were kept excessively low to keep the currency down.

But now, one can expect more interest rate hikes and a faster appreciation of the yuan. These factors would cool demand and provide some protection against rising commodity import prices. But yuan appreciation plus wage increases in response to the rising price of food is going to put huge pressure on export manufacturers, many already operating on the kind of wafer thin margins that encourage the use of cheap and unsafe materials.

After years of being static or falling, prices of U.S. imports from China rose 1 percent in the three months to July of this year. It remains to be seen how far price rises can be absorbed by importers, but there appears to be a clear break in the trend of low Asian import prices.

Strengthening of other Asian currencies against the dollar provides additional reason for a rise in China's prices, given the country's high proportion of imported components in many of its exports. With the Euro and many other currencies having appreciated faster than Asian ones, the incentives are limited for U.S. importers to switch from Asian to other sources.

For sure, inflation in developed countries is more a function of the service sector than either manufactures or food. Nonetheless, the impact of a weakening dollar and rising inflation in exporting countries can sustain price inflation even in the face of demand weakened by the sub-prime fallout. The China factor is here to stay.

Rising import prices should ultimately be beneficial for the U.S. economy, providing a means by which the trade deficit can be brought down to a sustainable level. Higher prices will eventually curtail import demand and cause shifts both to higher savings and to local products and services.

However, getting from here to there will be a painful process, most likely involving the recession that economics textbooks say is inevitable, but which long been avoided by a U.S. able to print its own international credit.