China Brakes, World Slows

China is now the world's marginal producer and sets global inflation rates. This is the result of cheap labor and a glut of manufacturing capacity.

Nobody knows exactly how much excess manufacturing capacity still exists in China. We do know that political pressures to preserve jobs or keep a politically connected factory owner happy have long kept inefficient factories in business. We also know that China's banks have kept pumping money into building new factories, among other things -- despite jawboning from Beijing to rein in lending growth to 8% from 9.1% in 2003. Commercial bank loans have been growing at 40% annualized rates recently.

Now, the "excess" factories weren't always particularly efficient, and they may have had problems meeting quality standards. But their very existence has kept constant pressure on manufacturers everywhere to cut costs and prices, and inflation has been low. Offshore companies have grown accustomed to shopping around their business on a regular schedule, looking for the best price. So they regularly compare costs and quality in China with costs and quality at home. Result: A lot of companies have moved manufacturing from, say, Chicago to Shanghai.

But there are signs that China may be ready to export inflation, not deflation. Inflation in China rose to 3.2% in the 12 months ending in December and 2.8% in the first quarter. So far, much of that increase has been in the cost of food. Here's where the commodity-heavy nature of the Chinese economy could become a real problem. As commodity prices rise, Chinese manufacturers must pass on much of that increase to their customers.

Leverage: As the supplier at the margin, any uptick in inflation in China quickly travels around the globe.