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From Say hello to China's Price/Wage spiral:

Like Japan in its heyday, China and India have been enhancing export competitiveness by maintaining artificially low currency rates. Their well publicized growth trajectories will be proved to be chimeras.

Well, China has been printing a lot of money for a long time in order to keep the Yuan low which befitted their export sector. As a result of their policy they accumulated massive foreign exchange reserves, and had giant trade surplus. Since China over one billion people and since most of them where farmers up until the 1990's the money printing didn't cause wages to rise dramatically. (Money flows to places where supply is tight and China had abundant labour).

So the money went into commodity, real estate, and stock prices in China. But now something totally different is happening. China trade surplus is gone, food prices are rising and wages too. This, combined with weak exports, a weak euro is killing China corporations margins and we have a classic wage and price spiral.

From China's Coming Depression and the Peak Of Deflation:

China's inflation is keeping oil prices uncomfortably high

China's money and credit supply is growing at an annual rate of 30%. Credit growth of 30% in China is equivalent to a 10% growth rate in the United States (Since China's economy is a 1/3 of the size of the U.S economy).

China's money supply (M2) is about the size of the equivalent number in the U.S(north of 8 trillion U.S$) So, the affect of the 30% growth rate in China's money supply is affecting the world's economy as if the United States M2 was growing at the same rate.

The Federal Reserve has stopped Q.E for that preciase reason- if it resumes Q.E it will face and oil price spike that will take oil above 100 per barrel. It is waiting for a market crash that will cause a collapse of oil price.

However, since China is inflating in such a rapid pace, oil prices are lagging the stock market and the EUR/USD. Although the dollar is up 20% versus the Euro oil has only fallen 10% from it's peak in early 2010.

China has been suffering from surging wage and food prices for the last few months. However, since there were a lot of restrictions on imports, prices in China were much higher than in the rest of the world, especially the United States and Europe. But recent developments signal that the arbitrage is starting to close. The direct implication of this development is that the Federal Reserve’s hands are tied even more, it simply can’t resume Q.E. until the demand from China cools down, and that is happening during a classic deflationary spiral in the Western economies.

The arbitrage in corn prices is being closed via a surge in exports from the United States to China:

China has purchased more U.S. corn this year than at any point since 1995 as soaring domestic prices and rising needs for livestock feed have boosted China’s demand for corn from the world’s top exporter.

One cargo of U.S. corn has already landed in China and started unloading and two to three more are scheduled to begin loading at U.S. ports this week, tempering at least some fears that China could not take delivery of the corn.

The concerns this year stemmed from China’s strict requirements for imported grain, including the need for import permits and phytosanitary certificates.

But China’s limited success in reigning in record high corn prices this year with sales from its state grain stockpiles increased the pressure on Beijing to allow greater corn imports. U.S. corn for shipment in the current September 2009-August 2010 marketing year, including 230,000 tonnes last week.

They also booked 60,000 tonnes of corn last week for 2010/11 shipment, although shipment of that corn is far from certain.

“China is sending the signal that they probably do want to be a buyer next year to keep the pipeline open and keep their prices in check,” said Don Roose, analyst with U.S. Commodities.

Net sales of U.S. corn in the week ended June 17 totaled 1.123 million tonnes for the 2009/10 marketing year and 332,300 tonnes for 2010/11.

It was the ninth time in past 12 weeks that total weekly corn sales have exceeded 1 million tonnes.

Total sales in the 2009/10 marketing year were 9 percent ahead of the same point a year earlier, compared with the USDA’s most recent forecast for a 5 percent increase in year-on-year corn exports.

And in the meantime, Chinese farmers are suffering:

For a Chinese entrepreneur fresh out of management school, pig farming looked like a one-way bet.

But Zhang Chengdu, who started his business in 2005 and bred as many as 5,000 pigs when pork prices peaked three years ago, now has half that number.

Although rising incomes have led to a huge expansion in demand for pork, the cost of corn, which accounts for 70 percent of animal feed, has risen much faster than pork prices.

‘‘Lots of farms are not breeding anymore,’’ Mr. Zhang said at his farm in Sichuan, China’s top pig producing province. ‘‘I am making losses every month. The money I earned over the last few years has all gone.’’ Feed costs have risen 20 percent this year, while pork prices are down 30 percent, said Mr. Zhang, who is losing between 200 and 300 renminbi, or $30 to $45, on every pig he sells.

The Chinese government, fearing an inflationary spike in food prices, has rushed to lower feed costs by selling government stocks of corn and acquiescing to imports of U.S. corn, normally all but barred in China because of genetic modification.

China’s demand for feed ingredients like soymeal and corn has outpaced its appetite for pork because of the modernization of the breeding sector, according to Alberto Weisser, chairman of Bunge, which has sold U.S. corn to China this year.

‘‘Until perhaps 10 or 15 years ago, there were not real large, commercial operations — hog or poultry operations,’’ he said at a conference this month.

‘‘And therefore most of the diet of the animals, of the hogs were table scraps. Small players have also lost ground in the last two years because of 3 billion renminbi in government subsidies to large-scale farms, said Guo Huiyong at Beijing Orient Agribusiness Consultant.

The subsidies, intended to improve food safety, have helped big farms add 10 million pigs. By contrast, on Ms. Luo’s small holding, it is hard to make ends meet.

‘‘We don’t have money to buy feed, corn powder and rice husks,’’ Ms. Luo said. ‘‘We owe someone a few thousand yuan, and he is chasing us for it. The only way to pay that back is if the pigs grow.’

The jump in exports is closing the arbitrage:

Corn futures surged nearly 8% after a U.S. government report cast a shadow over the outlook for supplies of the grain. The amount of corn stored on farms and in commercial facilities totaled 4.31 billion bushels as of June 1, according to the latest estimates from the U.S. Department of Agriculture. While that is up 1.1% from a year ago, it came in well below analysts' expectations. The world's largest corn grower, the U.S. harvested 13.1 billion bushels last year. Corn for July delivery recently traded up 25 cents, or 7.7%, at $3.50 a bushel on the Chicago Board of Trade. The most actively traded contract, for delivery of corn in December, jumped 7.8% to $3.7025. Most contracts opened the day's trading up 30 cents, the daily limit for moves in the price of corn in either direction. The rally comes just one day after the grain hit nine-month lows on weather conditions in the Midwest that were favorable for crops. The inventory figures and other acreage data "represent a significant bullish surprise for a corn market that appeared increasingly—and fundamentally perplexingly—bearish of late," said Lewis Hagedorn, an analyst with J.P. Morgan Chase. The number of acres dedicated to corn planting this year totaled 87.872 million, also below forecasts. Collectively, the two reports reduced expectations for U.S. corn supplies by roughly 500 million bushels. The USDA's estimates are "almost unbelievable," said Rich Feltes, senior vice president of research for MF Global. He said that corn futures prices probably have already established their lows for the summer. Wednesday's corn data could have implications for ethanol, a motor fuel that in the U.S. relies on corn as its main feedstock.

Ethanol producers have been lobbying the government to increase the amount of ethanol allowed to be blended in gasoline from 10% to 15%, or "E-15." The request is opposed by some engine manufacturers, and livestock producers worried about the cost of corn for feed. Mr. Feltes said the report could revive the "food-versus-fuel" debate because less corn will be available to make the biofuel.

Prices in China, on the other hand are stabilizing for the meantime:

Corn prices in China's major producing areas were mostly stable in the week to Wednesday as U.S. shipments began to offset supply tightness and set the stage for falling corn prices in the months ahead.

Prices in Qinggang in Heilongjiang province were at CNY1,780-CNY1,800 a metric ton, unchanged from a week ago. Prices in Changchun in Jilin province were also largely unchanged around CNY1,800/ton, said Xu Wenjie, an analyst with Tianma Futures Co. "The U.S. corn shipments and ongoing government monitoring (of the minimum price system to ensure fair and stable prices) are likely to keep exerting downward pressure on spot prices," Xu said. Some analysts say that worries about a moderating pace of economic expansion in China may translate to lower demand for livestock feed and food, which could add further downside for corn. About 1 million tons of corn are due to arrive from the U.S. this year, which is expected to relieve shortages in China due to unfavorable weather last winter. The first U.S. cargo arrived last week in Longkou port in Shandong province. A second shipment of 55,000 tons is expected in July, a Beijing-based official with the U.S. Grains Council said Wednesday.

What these articles are not telling you is that the main reason for the surge in China’s food prices is the fact that money supply is still rising at almost 20% annually. All the imports in the world will not prevent food prices from rising under these conditions. As long as the yuan remains stable versus the U.S. dollar, China’s inflation will impact the world via higher grain prices, since a growth in the money supply in China will have the same impact on global money supply as if the Fed itself was doing the printing.

However, what could happen is that China will continue to print money in order to prevent unemployment from rising and in fear of a housing crash. In that case we might see a yuan devaluation.

Under those circumstances food prices will rise in yuan terms but will fall when priced in U.S. dollars.

How to trade the closing of the arbitrage

Crop prices in the Western world are at multi decade lows adjusted for inflation. On the other hand, the price and earnings of agriculture companies are much higher. Potash Corp., for example, is 100% above its low set in December 2008 while the ETF for agricultural crops (NYSEARCA:DBA) is near its all time low. The reason for this price discrepancy is not that the market has gone crazy. Companies like Potash (NYSE:POT) had a good year because they sold to China, where crop prices were much higher. As the global price arbitrage in crop prices will close, so will the gap between potash prices and wheat, corn, and soybean prices.

So a trade: Long DBA and short Potash (POT), Monsanto (NYSE:MON), etc. makes a lot of sense.

We could see crop prices fall even further, but that will happen only after China’s economy totally collapses. And even in that scenario, the price of companies like Potash and Monsanto will fall a lot more.

Disclosure: Short China, Rio Tinto (RTP) and Potash Corp. (POT), long gold and DBA

Source: China's Food Price Inflation Is Starting to Affect the Rest of the World