Why China Should Raise Its Currency Instead of Interest Rates

China's decision to raise interest rates to contain food and housing price increases is a missed opportunity to move the country toward a more domestic-oriented economy. All Beijing had to do was boost the value of the yuan, its national currency, to reduce the emphasis on its export sector, but there's no evidence that such a major change is likely.

Chinese Premier Wen Jiabao acknowledged on Sunday that China's inflation rate -- up 5.1% in November compared with a year ago -- "made life more difficult" for lower-income Chinese, the bulk of the nation's population. But he vowed that the government is "completely able to control the overall level of prices."

On the previous day, Christmas, China's central bank raised interest rates by 0.25% to 5.81%, the second increase in just two-and-a-half months. On Sunday, it also hiked mortgage rates by 0.25% to 4.30% for loans longer than five years in an effort to contain the country's overheated housing sector.

Where the Price Pressures Are

JPMorgan Chase said in a note to clients on Sunday that it expects the Chinese to raise rates three times in 2011. But is this the best way to control inflation?

Barry P. Bosworth, a senior fellow at the Brookings Institution, says increasing interest rates will have the same effect in China as it does in the U.S.: slowing demand. Some economists expect Chinese growth to fall to 9% or less in 2011 from 10% in 2010.

Bosworth says most of the price pressure is coming from wage increases in the coastal provinces, the home of China's export industries, where labor supply shortages are beginning to emerge, and from imported raw materials. "The easy way to control that is to shift the mix of production more toward continuing to stimulate domestic demand and rely less on the export sector," Bosworth says. "From the U.S. point of view, the way to do this is just let the exchange rate appreciate."

For the Yuan, a Scant Rise So Far

But Bosworth acknowledges that there appears to be a "big battle" within the Chinese government over whether to let the yuan appreciate against the dollar. Many Chinese exporters have complained that they'll be unprofitable if the exchange rate is allowed to climb, a threat that carries heavy weight with the government because it's concerned about a higher yuan's possible impact on unemployment.

But allowing the exchange rate to rise would reduce the cost of imported goods such as foodstuffs like soybeans, which would benefit all of China's economy. Raw materials would also be cheaper in domestic currency terms.

Yes, Beijing announced in June that it would allow the yuan to appreciate, but the currency has gained only around 3% against the dollar. Many economists in the U.S. believe the yuan is between 30% and 40% undervalued against the greenback.

One Positive Development

The higher interest rates mean depositors will get paid more for their money. The government hopes that will lure them away from making investments in the housing market, a main cause of inflation. But with inflation at 5.1% and the interest on deposits at 2.75%, depositors are still losing money by keeping their cash in the bank.

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Bosworth does note one positive development from the interest rate hike: Beijing seems to be moving toward a market-based system of regulating monetary policy. In the past, government officials used to set different reserve requirements for banks and also set loan targets. "That's kind of an awkward way to run monetary policy in a more developed financial market," he says.

The Beijing government has expressed concern about "hot money" from abroad coming to China because of the higher interest rates. But, again, instead of allowing the yuan to appreciate, it's talking about imposing more controls on the flow of capital. Perhaps at some point, China will relent and let the yuan rise enough to have the desired cooling effect on the country's economy. That point isn't in sight yet.