China's Inflation Problem Looms Large
By Peter Schiff - January 20, 2011

The global economy has become so unbalanced that even government ministers who would normally have trouble explaining supply or demand clearly recognize that something has to give. To a very large extent the distortions are caused by China's long-standing policy of pegging its currency, the yuan, to the U.S. dollar. But as China's economy gains strength, and the American economy weakens, the cost and difficulty of maintaining the peg become ever greater, and eventually outweigh the benefits that the policy supposedly delivers to China. In the first few weeks of 2011 fresh evidence has arisen that shows just how difficult it has become for Beijing.

Twenty years ago, China's leaders decided to ditch the disaster of economic communism in favor of privatized, export-focused, industry. The plan largely worked. Over that time, China has arguably moved more people out of poverty in the shortest amount of time in the history of the planet. But somewhere along the way, China's leaders became addicted to a game plan that outlived its usefulness.

In order to maintain the peg, China must continually buy dollars on the open market. But the weaker the dollar gets, the more dollars China must buy. And with the U.S. Federal Reserve pulling out all the stops to create inflation and push down the dollar, Beijing's task becomes nearly impossible.

Last week, it was announced that China's foreign exchange reserves, the amount of foreign currency held at its central bank (mostly in U.S. dollars), increased by a record $199 billion in 4th quarter 2010, to reach $2.85 trillion. These reserves currently account for a staggering 49% of China's annual GDP (if the same proportional amount were held by the U.S., our measly $46 billion in reserves would have to increase 163 times to $7.5 trillion).

In order to buy these dollars, the Chinese central bank must print its own currency. In essence, China is adopting the Fed's expansionary monetary policy. In the U.S. the inflationary impact of such a strategy is mitigated by our ability to export paper dollars in exchange for inexpensive Chinese imports. Although prices are rising here, they are not rising nearly as much as they would if we had to spend all this newly printed money on domestically produced goods. The big problem for China is that, unlike the U.S., the newly printed yuan are not exported, but remain in China bidding up consumer prices. As a result, inflation is becoming China's dominant political issue.

It was recently announced that in November China's consumer price index rose 5.1% from the same time a year earlier, with food prices rising more than 10%. As unrest builds, the Chinese government has unleashed a series of policies to address the symptoms of the disease while ignoring its root cause.

The feeblest of these attempts is the imposition of price controls in many Chinese cities. But as President Nixon found out in the early 1970s, the laws of supply and demand cannot be suspended at will. The Chinese leaders realize this and have more recently implemented a raft of seemingly more sophisticated responses.

Informed by the mistaken Keynesian economic principle that inflation is created by a strong economy rather than by an expanding money supply, China is hoping to solve its problems by restraining growth. To do this it has just raised interest rates and has moved to restrict bank lending.

On Friday, the central bank said it will raise the share of deposits banks must keep on reserve by half a percentage point. This comes after six such increases last year (the fourth hike in just two months). On the interest rate front, the People's Bank of China is mulling further rate increases, which many analysts expect to come in the first quarter. However, if these moves are not accompanied by a cessation of dollar purchases, they will do nothing to control inflation.

This week, Chinese president Hu Jintao arrives for a summit in Washington, where he will get an earful from President Obama and Treasury Secretary Geithner about the importance of letting the yuan appreciate. On this point, the Administration actually has it right. But they fail, of course, to grasp the full implications of how a falling dollar and a rising yuan will hurt the U.S. economy. If the Chinese stop buying dollars, Americans will face higher prices and higher interest rates. If Geithner thinks we can take such changes in stride, he is in for a rude awakening.

The real awakening will occur when China realizes that it has tethered its economy to an un-tethered currency. There are plenty of signs that many in the Chinese leadership are beginning to fully grasp the problem.

For example, Zhou Qiren, an academic adviser to the People's Bank of China, said in an interview in the latest edition of China Reform Magazine that China should find a method of valuing the yuan that does not involve the printing of more yuan to maintain exchange rate stability. He argued that raising interest rates won't solve the fundamental problems behind inflation. To do that, China must control its money supply. I think he's on to something.

He also commented that the U.S. dollar, which became a substitute for gold as a result of the 1944 Breton Woods agreement, can no longer be serve as the anchor for world currencies. He further suggested that the yuan be linked to something objective. It sounds to me like he's talking about a certain yellow metal.

The bottom line is that the Chinese are finally waking up. When the dollar was backed by gold, it was a reliable anchor. However, once that anchor was cast aside, the dollar was set adrift, and is no longer positioned to provide stability. For a while, even without gold, the strength of our economy and the competitiveness of our exports gave stability to the dollar, but those moorings have snapped.

For now the old guard in China still holds sway and the status quo remains intact. But new leaders are expected to be in place by 2014. When fresh hands take the wheel, we may finally see some meaningful change in the global monetary system.

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