High Expansion. Low Inflation. What Gives?

China's boom, heady investment, and growing trade make for a potent combo

The world economy is cooking. Global output will expand 5% this year, the International Monetary Fund predicts -- the biggest rise in nearly three decades. The U.S. has pulled out of a slowdown earlier this year and looks set to post 4%-plus growth in the third quarter. China is likely to grow a sizzling 9% this year, and Japan is enjoying its best performance since 1990. Even long-lagging Europe is looking up.

In the past, such a strong, synchronous upswing would have set off inflation-phobes' alarm bells. Indeed, stronger demand has pushed up prices of global commodities, and especially oil. But so far, those price hikes haven't sparked broad-based inflation. Excluding food and energy costs, consumer price inflation worldwide is running at less than 2.5%, IMF data show.

So, what's going on? Over the past decade or so, the global economy has undergone fundamental changes that are conspiring to boost growth while keeping prices in check. These shifts include the continuing productivity revolution in the U.S. as well as the determination of the globe's central banks to keep prices under control. But the mother of all change agents is China -- a rising economic power whose soaring demand is fueling growth across the globe, even as its surge in low-cost manufacturing exports on the back of an undervalued currency is helping keep inflation in check from Des Moines to Düsseldorf.

The question facing policymakers is how long China can maintain this tricky balancing act of being both a source of growth and of disinflation for the rest of the world economy. Already, some danger signs are starting to emerge. Inflation is rising in China, and trade frictions with the U.S. are growing in response to the communist giant's super-charged export juggernaut. While the forces that are currently keeping China aloft and global inflation under control may not reverse anytime soon, the risks are clear. "The situation is not sustainable," according to former IMF official Morris Goldstein, now at the Institute for International Economics, a Washington think tank. "Something has got to give."

Indeed, China's economic development strategy is causing strains of its own. In 2 1/2 short years, China has gone from a deflationary pricing environment to annual inflation of 5.3% in August. Behind the marked turnaround: pell-mell economic growth, an ultra-easy monetary policy, and a bank lending boom. Perhaps even more surprising in a nation of 1.3 billion people, there have even been reports of spot labor shortages in China and rising wages.

HUGH CAPACITY

So why isn't China exporting its inflation to the rest of the globe? Credit largely goes to its massive investment in capacity. With investment running at some 45% of gross domestic product, China is adding capacity at a furious pace to make everything from steel to cell phones. Yes, its appetite for materials to fuel those factories is pushing up prices for oil and other commodities. But its exports of cheap consumer goods from those factories hold down inflation in the U.S. and elsewhere.

That huge build-up holds risks of its own, and the Chinese authorities have used jawboning and other administrative measures to try to rein in the nation's investment boom. The growth of fixed investment has slowed somewhat: From a 50% annual pace in January, it fell to 26.2% in August. Still, that's an enormous amount of investment in the pipeline, and China will need years to put all the capacity to use. "This is a process that will work out over years, not quarters," says China expert Nicholas R. Lardy, also of the Institute for International Economics.

RETALIATION?

China's export-driven strategy is promoting strains in its trade ties with the U.S. as well. The U.S. trade deficit with China jumped 28% in the first eight months of 2004, fanning political pressure in Washington for retaliatory action against Beijing. If that happened, it could trigger a nasty trade war that would undercut the global economy.

China has resisted the one step that economists say would help it curb its trade surplus with the U.S.: revaluing its currency. Allowing the yuan to rise would cut the prices of its raw material imports while raising the prices of its exports. At the G-7 meeting on Oct. 1, Chinese policymakers rebuffed U.S. calls for a timetable to adopt a more flexible currency system. But Washington is unlikely to back off -- especially if the end of textile quotas in January allows China to dominate completely the global apparel industry; that will almost certainly prompt more calls for yuan revaluation.

While an eventual rejiggering of the Chinese currency would narrow the American trade deficit, the news wouldn't be all good. Chinese goods would quickly garner higher prices, bringing an end to the nation's deflationary role. And if other Asian nations followed Beijing's lead and allowed their currencies to rise -- as many experts think they would -- the jolt to global inflation could prove significant.

So far, the reconfiguration of the world economy around the U.S. and China has proved to be a net plus. The change has helped hold down inflation levels even as it promotes global growth. But it has also spawned economic imbalances that will need to be dealt with if the good times are to continue.

By Rich Miller, with Pete Engardio, in Washington, and Dexter Roberts in Beijing

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