Since the 1990s, China has been a one-country check on global inflation. The intense competition from its factories drove a race to the bottom for costs everywhere.

Until now. China’s factory-gate inflation is surging at the fastest pace since 2008, just as prices heat up throughout the West. This raises the specter that the top two economies will suddenly face overheating risks.

In May, Chinese producer prices jumped 9% year-on-year, an acceleration from an already high 6.8.% rate in April. The biggest increases were in chemicals, metals and oil, but cost increases are spreading to raise the odds Chinese exporters will begin passing higher costs first to consumers – and then to the world.

“China’s producer price gauge is surging,” says analyst Thomas Gatley of Gavekal Research. That is “stoking fears that the country is both succumbing to global inflationary pressures and stirring them up.”

The good news is that this is not yet a given. As economist Iris Pang at ING Bank notes, China Inc lacks broad pricing power despite accelerating gross domestic product (GDP). “Producers,” she says, “have to eat up these costs.”

In the interim, President Xi Jinping’s government is springing into action to cap prices.

So far, it has cracked down on speculation in commodity prices and hoarding of vital materials. It’s working to lobby coal producers and steel makers from profiteering at such a fragile moment — vowing to probe reports of price-gouging. It also is allowing the yuan to appreciate to reduce imported-inflation risks.

A Chinese coal worker shovels the fuel in a file photo. Image: Agencies

Talk of firm price controls on coal coincided with Beijing’s moves to clamp down on cryptocurrency use. The mining of crypto assets is extraordinarily electricity-intensive, upping global demand for fossil fuels.

Xi’s efforts to cap prices are more global in scope than meet the eye.

Traumatic memories of 2015, when Shanghai’s benchmark plunged 30% in a matter of weeks, are very much in view. Back then, plunging stocks made headlines everywhere and slammed market capitalizations from New York to Tokyo. At the time, some punters warned China was experiencing its “Lehman moment,” just as Wall Street had seven years earlier.

The Chinese Communist Party summoned the full resources of the state to avoid tarnishing the national brand globally, and Xi’s men took an everything-but-the-kitchen-sink approach. Beijing regulators loosened leverage and reserve requirement standards. They halted initial public offerings and trading in thousands of listed companies.

They allowed punters to put up apartments as collateral so they could buy more shares. They urged average Chinese to buy the market out of patriotism. The People’s Bank of China slashed borrowing costs to reduce default risks.

It worked. Yet in the years since, Xi’s government has been trying to mop up the fallout.

The resulting debt, leverage and the size of the shadow-banking system — well beyond the $10 trillion mark — have now created control problems. Look no further than the ongoing default drama at China Huarong Asset Management, one of the nation’s so-called “bad debt” managers.

Contagion chatter is complicating Xi’s 2021. The selloff in China Huarong bonds recently spread to at least three similar funds: China Cinda Asset Management, China Orient Asset Management, and Great Wall Asset Management. The three peers have combined liabilities of at least $454 billion.

The People’s Bank of China. Photo: Xinhua

China Evergrande Group, the world’s most indebted developer, which owes more than $100 billion, also has investors in a whirl. The Financial Stability and Development Committee, Beijing’s top regulator, is asking lenders to do a round of stress tests to measure their health should China Evergrande stumble.

The fact that the directive has been circulated to giants like the Industrial & Commercial Bank of China speaks to the level of concern.

That has Xi and People’s Bank of China Governor Yi Gang trying to balance deleveraging efforts while still ensuring China’s “V-shaped” recovery narrative extends into 2022 even as new Covid-19 waves emerge. And now, add a third challenge to the list: avoiding an inflation outbreak.

Inflation brake or engine?

China’s global image is bruised enough – from its opaque response to the pandemic to its clampdown in Hong Kong to its exploits in the South China Sea. Belatedly, Xi appears to be realizing that Beijing squandered the soft power bonanza that four chaotic years of Donald Trump left at its doorstep.

Case in point: Xi’s recent instruction to his “wolf warrior” diplomats to cultivate a more “lovable” aura in geopolitical circles.

Exporting inflation is the last thing Xi wants, notes Louis Kuijs at Oxford Economics. Though China isn’t sharing rising costs with the globe, “from a US perspective, rising prices of imports from China may start to feature in the debates about inflation there.”

If commodity prices continue skyrocketing, inflation scares “will become a significantly larger problem – globally and in China.”

In yuan terms, Kuijs notes, it might not seem that China is about to export inflation. Yet in dollar terms, the calculus could change rather quickly.

US Treasury Secretary Janet Yellen. Photo: AFP

Michael Hewson at CMC Markets notes that China’s “inflation data for May is another example of rising inflationary pressure in the global economy.” Some of this increase can be attributed to base effects because of big drops in prices in 2020.

But, Hewson says, “There is increasing evidence that various supply-side issues are starting to create a situation where, rather than being transitory, inflation pressures could become more persistent.”

Hewson continues: “It’s certainly something Chinese business is becoming more concerned about, along with Chinese authorities, given recent steps to curb the recent sharp rise in commodity prices. This is a situation that central bankers appear to be remarkably relaxed or complacent about, depending on which side of the fence you happen to be on.”

All quiet – for now

Currently, though, Chinese consumer prices are reasonably contained. The latest series of data releases is up just 1.3% from a year ago, lower than estimates that foresaw a 1.6% increase. The upshot is that the many pockets of sluggish demand in Asia’s biggest economy give retailers little room to hike consumer price tags.

This means China is playing something of a shock-absorber role globally. But for how long?

The broad disconnect – between forecasts for 8% GDP growth in 2021 and fragile demand – explains why Yi’s team at the PBOC views inflation pressures as transitory.

So does US Treasury Secretary Janet Yellen, herself a former central bank head. Speaking in London ahead of this weekend’s G7 summit, Yellen said: “We’re seeing some inflation but I don’t believe it’s permanent.”

She explained that she expected year-on-year inflation to come in at a manageable 3%. Yet, Yellen cautioned, officials in Washington and beyond must remain vigilant. “I don’t want to say this mind is absolutely made up and closed,” she noted.

Talk of a step up toward 3% Chinese inflation also is making the rounds in markets. As strategist Ken Cheung at Mizuho Bank sees it, the PBOC “should have no urgency to tighten” given the “still benign” trends in consumer prices.

But a solid break above 3% could change the calculus.

A shopper at a supermarket in Hangzhou city in east China’s Zhejiang province, October 15, 2020. Photo: AFP / Stringer / Imaginechina

This is, after all, a moment of some confusion for officials from Yi in Beijing to Fed Chairman Jerome Powell in Washington. “Why,” asks economist J.P. Mayer of Pacific Wealth Management, “are US Treasury yields sliding while inflation expectations are rising?”

To him, three different forces are helping to keep 10-year US yields at around 1.5%: the Fed, Chinese authorities and walls of US institutional money.

The Fed, of course, has been on a bond-buying tear in recent years, a dynamic that caps rates not just in the US but virtually everywhere.

China, meantime, has amassed a huge trade imbalance with the US, a side effect of which is a stronger yuan. Mayer notes that “as commodities prices, which are denominated in US dollars, have surged, it has created inflationary pressures for China’s manufacturing economy.”

To be sure, Mayer says, “a weaker yuan is also of benefit to their export-driven economy. To achieve a weaker yuan and stronger dollar, China has undertaken a two-pronged approach: buy US Treasuries and raise the FX reserve requirement for Chinese banks.” The trouble, Mayer says, is that all this buying warps market dynamics and gives punters a false sense of comfort.

“This is essentially market manipulation by various participants to achieve their own objectives,” Mayer says. “The Fed to keep rates low, China to weaken the yuan and strengthen the dollar and US institutions to reach target allocations. Meanwhile, market inflation expectations continue to increase.”

The globe’s disinflationary engine these last three decades appears to be going out of commission. The risk now is that China morphs into an inflation exporter in ways that impact an already struggling national image. That really is the last thing Xi wants in 2021.