Can China Tame Its Inflation Dragon?

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Chinese inflation dragonChina is raising interest rates for the third time since October in an effort to quell inflation at home. But the signs are growing that it may not be able to keep the problem under control.

"The tightening of monetary policy is way under what they need to do," says Jeffrey Bergstrand, a professor of finance at the University of Notre Dame. "Once you get to these high inflation rates, they are at risk of moving to hyperinflation, and that always leads to some kind of a clampdown in the future and a bubble burst in terms of demand."

In an unusual move, the Bank of China used the last day of the Chinese New Year's holiday to boost its one-year lending rate by a quarter of a point to 6.06%, and it raised the one-year deposit rate by a quarter point to 3%.

More Rate Increases Coming?

Inflation in China was running at 4.6% in December, but it's widely expected to be above 5% when the January figures are announced next week, thanks to much higher food prices on the world markets. Food is typically 40% of the Chinese household budget.

"There are plenty of reasons to expect inflation to pick up further in the next few months," Brian Jackson, an economist for the Royal Bank of Canada, said in a note to clients Tuesday. He said he expected a further half-point rate rise later in the year.

With a two-point gap between inflation and the interest rate paid by bank deposits, it's likely Beijing will have to keep raising rates to prevent prices from spiraling out of control. China raised interest rates by a quarter-point in October and December. It has also increased reserve requirements for banks in an effort to reduce lending.

Don't Expect the Yuan to Rise

Bergstrand says a major problem is that the Chinese government doesn't have an effective way of measuring inflation and relies mainly on anecdotal evidence such as wage increases. Minimum wages have gone through the roof recently, rising at double-digit rates in the coastal areas where most of the export industries are located.

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"The very difficult thing is they themselves don't even have a good idea of how rapid inflation is," Bergstrand says. "It could well be running at double-digit rates." He adds that export prices have been rising above 10% a year recently.

Bergstrand says despite the jump in inflation and the threat it poses to the economy, the Chinese seem unlikely to allow the exchange rate for their currency, the yuan, to move higher against the U.S. dollar because of pressure from domestic export industries.

"For the next couple of years, they'll probably let the yuan appreciate in nominal terms, but they're going to manage it heavily so it's only going to change a small percentage point," he says.

The Chinese don't allow the yuan to trade freely and set the exchange rate against the dollar to make exports cheaper. But allowing the yuan to rise in value, causing food imports to become cheaper, could solve the Chinese inflation problem.

A Boost for U.S. Exporters

U.S. Treasury Secretary Timothy Geithner is currently in Brazil, trying to drum up support for concerted international action to force China to change its exchange rate policies. The Brazilian economy also competes with China and has suffered.

Bergstrand says if China does allow the yuan to appreciate, some U.S. exports such as capital goods and high technology, might see increased sales there.

"China does not fix the exchange rate against the euro and the yen, so the relative price of our exports is kept artificially high relative to our competitors," he says. Bergstrand adds that an upward appreciation of the yuan would make U.S. exports more competitive, especially against big exporters like Japan and Germany.

Here's another impact of rising inflation in China: U.S. importers like Walmart (WMT) are likely to start moving their production to other manufacturing sites in Southeast Asia so they don't have to pay higher wage bills to the Chinese.

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