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ICG Risk Blog - [ The Mu shu pork Index for predicting Chinese propagation of inflation ]

The Mu shu pork Index for predicting Chinese propagation of inflation


If you manufacture product in China as part of your global supply chain or purchase Chinese products for inclusion into your manufacturing or processing efforts, you should pay attention to what we are calling the Mu Shu Pork Index in the spirit of the Economist's Big Mac Index (1986) and Starbucks Tall Latte Index (2004). But whereas the Big Mac and Starbucks Indices are based on the theory of purchasing-power parity (PPP) that argues that exchange rates will, over time, equalize the price of identical baskets of goods and services in any two countries, our Mu shu Index will define a basket of effects that will flush rising costs and inflation through the Chinese economy and out into the global supply chain that absorbs Chinese product.

End of the low cost, labor intensive inflationary brake

The intersection of a litany of Chinese adulterations and contamination of pharmaceuticals, food stuffs and commodities with the skyrocketing cost of pork, the meat staple of every Chinese, all set against unease in the bond markets triggered the need for an inflation index that could be propagated globally.

With the global economy expanding at a robust pace, and prices rising in fast-developing countries like India and Mexico, central bankers and investors are becoming concerned. Interest rates are inching up in the United States and Europe as lenders demand that borrowers pay more to offset the erosion of buying power over time...

Heavy investments in new factories, roads, rail lines and ports have helped limit inflation until now in manufactured goods, as productivity improvements mostly offset rising wages and higher prices for food, oil and metals. Economists and business executives say that manufacturers face growing pressure to raise prices as well, particularly with the torrent of money pouring into China, which has helped push up the prices of Chinese stocks and real estate.

Prosperity driven consumption, wage inflation and commodity increases have driven up prices for Chinese pork, chicken, fish, beef and eggs but pork's rise has been so great that the CCP was taken by surprise, ordering municipal subsidies on pork purchases. (In less than two months (March-April), live pig prices rose over 70% while pork was up almost 30%, both continuing to rise into May. Meat prices alone are contributing one % to the inflation rate.) Inflation is back in China, driving up wages and resource costs and will shortly drive up export prices; China's low cost labor intensive market is about to come to an end, ending an inflationary brake to the US/EU.

Cost cutting by other means; Cutting corners is an open secret in China

Pork is not the only inflation driver. Removing thinly veiled dysfunctions and dangerous shortcuts in Chinese supply chains will add cost.

"We're now learning some of the dirty secrets behind this fast-growing economy," said Wang Fei-ling, a professor of international affairs at the Georgia Institute of Technology. "And the dirty secret is they're cutting corners in making things."

Students of the Chinese manufacturing environment find such comments naive or at least inattentive to facts on the ground. Cutting corners has been a general manufacturing characteristic of Chinese firms even at the higher end, automotive market and associated components. Whereas processes such as APQP (Advanced Product Quality Planning) have long been standard in the North American and European market, US/EU Tier One automotive suppliers often talk of having to endure "good enough" production where the Chinese manufacturer decides what is good enough - and where it cannot be seen, notably in materials, coatings and plating - components have an increasingly high probability of being far from 'good enough.' In conference after conference on Chinese manufacturing, one hears firms lamenting that good Chinese suppliers are hard to find if they are skilled (as their production capacity is already saturated) or if they are not, requires patient and expensive training before a reliable product stream is produced. (And once you've trained them, they are likely to shift away from you to other clients willing to buy your training at a discount.)

The aforementioned does not mean that the Chinese are incapable of superb production; Far from it, especially in a national security environment. In an analogous condition, one remembers Russian manufacturing technology in early MIG-21 Fishbed fighters which often resembled what we liked to call 'rusty beer cans' yet the same aircraft's afterburner ceramic coatings (which suppressed the ionized gas plume detectable by VHF search radars) was state of the art. China is capable of world class production; This article is addressing commonly available Chinese commercial manufacturing and processing.

The PRC is, certainly has, attempted to portray two Chinese firms, Xuzhou Anying Biologic Technology Development Company and Binzhou Futian Biology Technology Company, found to be exporting melamine-tainted wheat flour to the US as "rogue companies, or "special individual cases" in a largely well-managed export industry," but such efforts to box the breach "seems quite at odds with local Chinese agricultural industry executives:"

In recent weeks, they have said in interviews that for years producers and feed makers have either used melamine in animal feed, sold it to animal and fish feed producers or knew of the sale and use of melamine in animal feed. Interviews with animal feed producers, melamine makers and melamine and feed traders suggested that it was a widespread practice to mix melamine into feed to deceive buyers into thinking they were getting higher-protein meal.

Most of the people interviewed said they did not believe that the practice was illegal or that melamine was toxic in animals or humans; the melamine was simply filler, most of them said, a way of earning extra profits. They did say, however, that it was also mixed secretly, otherwise buyers would know they were being cheated out of protein. "Our clients who buy melamine scrap to make animal feed are mainly from Shandong Province," Qin Huaizhen, manager of the Gaocheng Shunkai Chemical Factory in Hebei Province, said two weeks ago. "They use melamine scrap to produce fish, chicken and other animal feed." He went on to add: "Clients use it to boost the protein level."

Be it ethylene glycol in cough syrup, contaminated melamine in pet food, or lead in baby bibs and children's rings, Chinese firms have more to overcome than fears of "Made in China" morphing into "Buyer Beware." Their manufacturing costs will have to rise as they remove the short cuts. Old habits will die hard, province by province, city by city and plant by plant. The omens are not good that Chinese denials and information embargoes in the melamine contamination replicated those seen during the SARS and avian flu outbreaks, or that counterfeiters continue to follow industrial polluters into the interior of China in order to avoid exposure.

"Basically, for entrepreneurs, if something is not explicitly banned - it's not banned... As long as people are not sick or dying, it's O.K."

I predict that this correction will have a very long tail throughout the greater Chinese supply chain whose exports are currently pegged at over one trillion USD per annum, a tail that will affect many of the prosaic industrial, consumer and food items that populate the global supply chain.

What happens in the place of low cost labor products

Low skill, low wage jobs will shift to value-add, high skill industries. Here is one that will further upset existing OEM and Tier One suppliers in Asia, North America and Europe:

China's auto parts exports have increased more than sixfold in the last five years, nearly topping $1 billion in April and emerging as one of the fastest-growing categories of Chinese industrial products sold overseas. More than half of these auto parts go to the United States; most of the rest to Europe and Japan.

The rise of Chinese auto parts exports is part of a much broader shift. China is moving up from basic goods like textiles, toys and shoes and toward higher-value industrial goods that pay better wages - but also compete more directly with products from countries like Mexico and even from advanced industrialized countries like the United States...

Soaring output at auto assembly plants in China is generating enormous demand for auto parts and creating the economies of large-scale production previously possible only in North America, Europe and Japan. And with at least a half-dozen Chinese automakers planning to start exporting in the next few years, Chinese auto parts will soon be going overseas not just in crates, but as part of fully assembled cars.

Multinational automakers set virtually the same quality standards for their operations all over the world. They are working closely with Chinese parts companies to help them meet these standards; once they do, they are allowed to submit bids for supplying factories elsewhere.

Readers are referred to Sean McAlinden's work on the auto sector, two of which are cited here and here, for the impact of that industrial migration on US/EU OEMs and their suppliers. They will fondly remember the time when declining market share and inflation were their principal concerns. It will be instructive to construct the Mu shu basket.

UPDATE: Observation from a skilled senior operational staffer at a large Tier One with whom we have had ongoing discussions on IP protection methods for four plus years: "This [inflation] is to be expected."

My reply: "To the thoughtful, yes, but for those who ran to, or were driven to, China with the sole goal of low cost piece part pricing [leaving aside direct and indirect transportation costs due to delays, port crowding, lack of bottoms, etc.], this cost-up will come as a shock without an effective response." We discussed the similarity in the purchasing efforts of both GM and Ford which had driven suppliers to China purely to achieve lower piece part costs. He agreed with my assessment that those supply chains, and the suppliers therein, will face heightened vulnerability as they are unable to continue to meet cost-down demands, maintain margins, hold/build revenues and likely loan covenants from their banks.

Rise in China's Pork Prices Signals End to Cheap Output
New York Times
June 8, 2007

Yields on Treasuries Climb; Shares Tumble Again
New York Times
June 8, 2007

China to Revise Rules on Food and Drug Safety
New York Times
June 7, 2007

Chinese Auto Parts Enter the Global Market
New York Times
June 7, 2007

When Fakery Turns Fatal
New York Times
June 5, 2007

China Sentences Former Drug Regulator to Death
New York Times
May 29, 2007

An Export Boom Suddenly Facing a Quality Crisis
New York Times
May 18, 2007

China Urges U.S. Not to Punish All Food Exporters
New York Times
May 17, 2007

At Shanghai auto show, China carmakers in search of edge
By Keith Bradsher
April 22, 2007

China: Land of opportunity?
Oakland Business Review (Michigan)
November 2, 2006

The Economist
May 25, 2006

There's No Place Like Home: The Geography of Automotive Employment
Presentation to Chicago Federal Reserve Conference on "The New Geography of Auto Production"
Sean P. McAlinden
Center for Automotive Research
April 19, 2006

Coffee cup holds secret to currency forecasts
From Times Online
January 16, 2004

Burgers or beans?
A new theory is percolating through the foreign-exchange markets
From The Economist print edition
Jan 15, 2004


Disaster Deferred: The U.S. "Big 3" and the Labor Cost Squeeze
Glenn Mercer, McKinsey & Company, Inc.
GERPISA Conference
April 2003, Paris

Estimating the New Automotive Value Chain
A Study Prepared for Accenture
Sean P. McAlinden, David J. Andrea
Center for Automotive Research, Altarum Institute
November 2002

Gordon Housworth

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