In a recent interview (about a week ago), Marc Faber warned of a coming correction in asset prices. In this correction, he reckoned that emerging markets (e.g. China) will fall harder than the markets of the developed world (e.g. US, Europe).

As he elaborated further, for the past two years, the emerging markets and commodities were doing very well. In fact, so well that there’s talk that China’s economic/political model is superior to the model of the Western liberal democracies because it managed to dodge the GFC and thrived in the aftermath while the developed economies were going nowhere and being plagued by sovereign debt crisis.

However, Marc Faber reckoned that for the next few months, this trend can reverse for a change. The implication is that US Treasuries, US dollar may do very well, while US stocks may outperform emerging market stocks by falling less. So, the S&P500 may correct by say, 10% while Chinese stocks may correct by say, 20-30%.

For investors, it is easy to get lost in the minute details and lose sight of the forest for the trees. For one, it is clear to us that even though the massive money printing exercise of the Federal Reserve is not showing up in the US, price inflation is rearing its ugly head in the emerging economies. In other words, we believe that the US is exporting its price inflation to the emerging economies. This is because all nations are engaging in competitive devaluation of their currencies (to protect their exports in order to ‘stimulate’ their economies). However, since the US dollar is still the world’s reserve currency, the US is able to export the resulting price inflation to the emerging economies.

The price inflation had been growing for the past two years. At first, it seems benign and even seen as a badge of vindication for countries like China. And if you read our article, Turkeys fattened for slaughter in the Chi-tralia bubble, the growth and inflation is fueled by a massive credit bubble and monetary inflation. Since it is an axiom that all bubbles deflates/bursts eventually, there are speculation of when the bubble in the Chinese economy is going to burst.

Judging from the chatter in the blogsphere and mainstream news article, it seems that the spotlight is shifting towards the price inflation and asset price bubble in China. More and more articles like Crouching tiger, soaring cranes, rumbling doubts are telling us that there’re growing doubts on the Chinese economy. As we wrote 12 months ago in Chinese government cornered by inflation, bubbles & rich-poor gap,

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets.

Indeed, price inflation is turning into a serious problem in China. As Patrick Chovanec wrote,

China used to be cheap.? According to figures the World Bank uses to calculate Purchasing Power Parity (PPP), in 2003, a dollar?s worth of currency bought nearly five times as much in China as it did?the U.S.? A?bag of groceries,?or a hairdo, or a hotel room?that would have cost $50 in the U.S. cost only RMB?90, or roughly $11, in China.

Talk to anyone in China, though ? local or expatriate ? and they?ll tell you that, lately, things have been getting a lot more expensive.? When I went back to the U.S. a few months ago, I had the?strange sensation ? for the first time ? that a lot of things were actually cheaper there than in Beijing.

We are increasingly seeing signs that the Chinese government are taking more and more actions to attempt to control price inflation via administrative measures. But with money supply increasing 50% over the past two years, such measures are mere pin-pricks. The exploding supply of money is the root of China’s price inflation problem. And the reason why the money supply is exploding is the peg of the RMB towards the USD (see Why is China printing so much money?).

Unfortunately for the Chinese people, there are too many vested interests (e.g. corrupt officials, provincial governments, big businesses with links to government) in China who wants to keep the credit and asset price bubble going. Since asset price bubbles and price inflation are the symptoms of a common course (monetary inflation), the bias of the Chinese government (and for most governments in the world for that matter) is towards more inflation. Once the root cause of the price inflation is tackled, the asset price bubble will deflate/burst as well. With that, the massive wealth of many vested interests will deflate/disappear as well. Since we doubt those vested interests want that to happen, the price inflation problem will continue to rage in China.

Now, here comes a crucial point. As long as the masses in China believe that the government is working towards ‘solving’ the inflation problem, there are still hope. Indeed, a friend in China told us that her country (i.e. government) is “working its brains” to solve the inflation problem. Unfortunately, this is something that has yet to be dawned on her. As Patrick Chovanec wrote,

I find it incredibly ironic that the two hot populist issues among Chinese citizens these days are the high price of housing and U.S. pressure for a stronger RMB.? People are hot under the collar about both issues, but they never draw stop to think that China?s position on currency (maintaining a weak RMB) might be fueling inflation in the form of?rising housing and other living costs.? ?Of course, I don?t expect average citizens to draw the connection, but economists should.

However, the truth is this: the vested interests who control the government are NOT serious about solving the price inflation problem. The danger is that once the masses realise this, hyperinflation begins. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

So, as it becomes increasingly clear that the current trends in China is unsustainable, investors should watch the reaction of the Chinese government.