One Eye on China: Fighting Inflation Using the Yuan or Interest Rates?

Some members of the US Congress are publicly creating pressure on the government in China to allow their currency, the Renminbi or yuan, to float. The belief is that it would naturally rise in exchange for the US dollar in particular, making goods and services in China more expensive. The benefit to the US is that a more expensive yuan would increase the incentive for US companies to move production facilities from China to the US. (Of course, they may just move to another favorable currency economy but that will be after the elections. Right now the expedient political move is to pressure China.) In his article, Get the Yuan Right, Prove Pundits Wrong, Andy Xie describes his beliefs about the cause and effect issues surrounding the internal difficulties facing the government of China, price inflation and the mother of all housing bubbles, making their decision for what to do with the pressure from D.C. very difficult.

Andy Xie makes the following observations, "By all measures (stock value to GDP ratios, inventory value to GDP ratios, new property sales to GDP ratios, price to income ratios, rental yields, and vacancy rates) China's property market is one of the biggest bubbles ever. It's probably much bigger than the U.S. property bubble relative to GDP. 

Now, the same liquidity that fueled the property bubble is leading to rapid pickup for consumer price inflation. One just needs to look around to see the seriousness of the inflation picture, regardless of how it's measured. Denying that inflation is serious in China right now is akin to burying one's head in the sand. This sort of denial is how countries in Southeast Asia got into a crisis situation in the past: They kept real interest rates too low and fueled speculation that eventually destroyed their banking systems.

If China's economic stimulus is withdrawn, the property bubble will cool. And it may even burst. This is why so many interest groups consistently argue against higher interest rates. Instead, they support using currency appreciation to cool inflation.

Why is this policy option so popular among interest groups? Because it would fuel the hot money inflow, which in turn would support and expand the property bubble. Of course, inflating the property bubble will only worsen inflation. And the odds are that a small currency appreciation would only make the property bubble bigger and inflation worse.

In a standard economy, currency appreciation cools inflation by decreasing import prices. China's imports are mainly raw materials, equipment and components. A small currency appreciation would have virtually no effect toward cooling inflation. So while a small appreciation might be justified politically, it should not be used to fight inflation."

Inquiring minds might learn more on this topic from an earlier post titled One Eye on China: Are the Wheels Wobbling?  It's easy to see there are no easy solutions. This is exactly like the concerns the government of China has with the US fiscal policy. They are anxious to see an end to the growth of our enormous appetite for debt, exceeding our ability to resolve with our weak GDP.

This is really a tug of war between two mammoths that like to give commands, not receive them. It is not going to be a pretty match! I look for unsportsmanlike conduct from both sides. Scanner