China - Inflationary Pressures and the Exchange Rate

This BBC news video provides an interesting window on the pressures for wages to rise in the booming city of Shanghai. The impressive rebound in Chinese economic growth is driven by the strength of the underlying growth forces in the economy together with the impact of the huge fiscal stimulus. But for many young professionals growth is causing the cost of living to surge - food and property prices are the main concerns.

Inflation is a genuine risk for the Chinese economy - what might the Chinese authorities do about this?

Soaking up excess liquidity in an economy

What are the policy options available to the Chinese government?

Monetary policy is usually the first line of defence. China’s central bank last week unexpectedly raised the proportion of deposits that banks must set aside in a bid to curb the lending boom in the economy. Policy interest rates may also be raised further although this is unlikely to have much impact in the short term.

A third (and possibly significant move) would be to allow a gradual appreciation of the renembi-Yuan against a range of currencies including the US dollar.

A stronger currency can cool the growth of Chinese aggregate demand by limiting overseas demand for exports, and also by making imports of finished and semi-finished products less expensive. China’s government tried to counter the last surge in inflation, which began in 2007, with currency appreciation. The yuan gained about 15% against the dollar until authorities returned to an effective Yuan-US dollar fixed exchange rate in the late spring of 2008.

Too rapid an appreciation of the exchange rate would hit China’s export industries just a short while since they were affected by the global economic downturn in 2008-09. And if speculators know that the Chinese authorities are happy for their currency to appreciate, this may prompt a surge in hot money flows into the Chinese financial system from speculators thinking that the Yuan is a one-way bet. The last thing that China needs is another huge rise in the money supply from inflows of short term money. China already has the highest level of foreign exchange reserves of any country in the world.

It seems that the Chinese authorities do not regard the exchange rate as the most effective or appropriate tool to use as a way of keeping inflationary pressures in check. Their focus is likely to be on tightening credit controls within the domestic economy and using changes in policy interest rates. But there are signs in the currency markets that a new dollar-Yuan peg is not too far away.

There is of course another approach to engineering a change in real competitiveness between China and countries such as the United States. Instead of allowing the renembi to appreciate China could simply allow her economy to have a higher annual rate of inflation than the USA, this would have the same effect on the relative prices of traded goods and services as an exchange rate adjustment. This article in the Wall Street Journal makes the case for an inflation-led change in the real exchange rate and argues that it is a perfectly natural side effect of the rapid growth of emerging market countries.

“As a developing country, China is on the road from being a poor nation to being a richer one. As part of that process, everything in China will get more expensive over time: as Chinese incomes and wages rise closer to global levels, it becomes more expensive to produce goods and services, and their price also rises. In other words, some inflation is unavoidable if China is to become more prosperous and its consumers are to spend more.”

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