Inflation in raw ,materials and mining profits is very much greater...!

HOW DO YOU when inflation is hopping away like a rabbit? asks Dan Denning in his Daily Reckoning Australia.

When the People's Bank of China (PBOC) raises one year lending rates by 25 basis points from 5.81% to 6.06%. For the third time since October. That's how!

The PBOC has repeatedly raised lending rates, deposit rates, and reserve requirements at banks. Sounds like an inflation problem, doesn't it? Sounds like a credit bubble, doesn't it? Sounds like excessive lending leading to a huge boom in fixed asset investment (real estate), doesn't it? Sounds like the sort of thing that might be bearish for Aussie resource producers, doesn't it?
Or not!

Rio Tinto is due to report its 2010 profit results Friday. Word on the street is that Rio's full year profit will come in around A$14 billion, or more than double 2009's figure of A$6.3 billion. That kind of profit makes the Commonwealth Bank's first-half profit of A$3.34 billion look a little pedestrian.

It's definitely not 2009 anymore. Back then, the miners were licking their wounds from the GFC and dealing with lower commodity prices. But since then, commodity prices have rebounded. The combined stimulus efforts of China and America have unleashed much higher prices for tangible assets. Resource stocks loved it.

With Xstrata reporting a profit of A$5.12 billion and Oz Minerals even posting nearly A$600 million in profits, only BHP can spoil the party when it reports its results a week from today. But remember, these profit results are from last year. Even if the Efficient Market Theory is balderdash, these positive results aren't a surprise. They should already be priced into stocks.

What's not priced in is a China crash. Or at least much lower growth rates as the government in China tries to contain inflation. The repricing of resources and resource stocks on a China crash is the "other shoe" to drop on Australia. But it hasn't happened yet.

By the way, the "other, other shoe" to drop is a housing crash. That hasn't dropped either. That means Australia has both shoes in the air, ready to drop, like Wyle E. Coyote against a clear blue cartoon desert sky.

But maybe the resource boom will never really crash. At least not for another 15 years – according to David Gruen of the Australian Treasury. Gruen reckons, "The re-emergence of China and India into the global economy is the most important global economic development likely to have an impact on the industrial structure, and hence the demand for skills, in the Australian economy over the next 15 years."

If he's right, then this "one-off" event would sustain a continuous shift in the balance of power for resource pricing away from consumers and toward producers. All the capital spending and exploration in Australia for new projects would be justified. And profits to companies and shareholders would make everyone rich.

Thank you China!

But what if he's not exactly right? There are two ways of looking at the re-emergence of China and India. The first is that two 5,000-year-old civilisations are rapidly catching up with the industrialised West. For the world, this means flatter/falling wages (lower Western standards of living), lower prices for finished goods (more producers), but long-term support for real assets and presumably the companies that find, mine, or refine them.

If you're trying to reduce that to an investment strategy, it won't be easy. Where will the profits be? Two places, we reckon.

The consistent, plodding kind of profits will probably belong to entrenched incumbents. These should be safe but boring profits for long-term investors who have time on their side. Our colleague Greg Canavan keeps his eye out for the best time to buy the handful of Aussie companies that qualify as cash-generating blue chips that are very hard to compete with.

The bigger, riskier profits are obviously on offer for junior resource companies, especially the explorers. But finding which commodities have the most favourable dynamics and which companies can find and produce them the cheapest isn't easy. That's why we have several people who do nothing but look for those opportunities all day long.

Of course this whole first way of looking at the China story is exactly the way we were all looking at it in 2007. Before the GFC. But since then, we've learned that what's making these abnormal rates of Chinese GDP growth possible is an abnormal rate of fixed-asset investment. And what made THAT possible is an abnormal credit bubble.

Or, to follow the logic, China has condensed decades of economic development into a few years with the help of copious amounts of credit. This means China's story (like Egypt's) is, at heart, a currency story. But does that mean China's spectacular growth, like Mubarak's regime, will be a victim of the collapsing US-dollar empire? Or will China surpass the dollar and keep on trucking?

If you read our "Exit the Dragon" report on this subject a year ago, you already know where we're going. But it's been a year and still no crashing Dragon. What gives? We're updating that report for the February issue of the Australian Wealth Gameplan. Stay tuned.

In the meantime, you'll note that Gruen's report showed the decline of Australian manufacturing, in terms of both employment and investment. This is what Greg recently called the hollowing out of Australia's economy. It's what happened to America over a 30-year period and what caused the country to become an inveterate borrower as it consumed more than it produced.

Is Australia different? Well, it's exporting raw materials in record volumes even as the labour market shifts to selling things (services) instead of making them. But whether this is a long-term wealth strategy....or just a way of becoming another Chinese province...is yet to be seen.

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