Mainland Chinese Inflation

Mainland China is in an enviable position. Rapid economic growth, huge current account surpluses, and the world's largest foreign reserves all suggest a rosy future for the world's most populous country. But maybe not all is as well as it seems.

China's foreign reserves are reportedly growing by 1.5 billion USD per day. Such accumulation is generally the result of an undervalued exchange rate, where the currency trades at below its equilibrium value, supported by central bank intervention (although given China's currency controls, it is not clear where the equilibrium value of the RMB really lies).

If the currency were overvalued, there is a risk that the central bank would be forced to devalue the currency- for example, if it ran out of foreign reserves. This can have devastating consequences for the economy, as Thailand illustrated during the Asian Financial Crisis.

In contrast, the risks of an undervalued exchange rate seem mild. Supporting an undervalued exchange rate requires the central bank to demand foreign currency (bolstering foreign reserves) and supply local currency in return (increasing the domestic money supply). In principle, there are no limits to how long the central bank can continue doing this.

But it is not without negative consequences. As Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomena." Unfortunately for China, the relationship holds in both directions. If you print too much money, you will generate inflation.

When I read headlines such as this one on increasing mainland inflation, it makes me nervous. Friedman also argued that an increase in the money supply increases inflation, but with "long and variable lags," a statement that is accepted as fact by most monetary economists. I'm concerned that the disproportionate increase in the money supply resulting from foreign exchange accumulation may yet result in a large increase in inflation in the coming months.

Aside from the massive build-up of foreign reserves, there is additional evidence of a highly expansionary monetary policy in Mainland China. With consumers earning less than the inflation rate when they deposit money at the bank, real interest rates are effectively negative. That is hardly going to constrain the growth rate of a runaway economy like China!

China needs higher nominal interest rates, and soon. That might also help to burst that other problem of the equity price bubble, before it gets worse.