No Deflating Red-Hot China

11/18/2010 12:10 pm EST

Focus: MARKETS

Robert Hsu

Editor, China Strategy and Asia Edge

Robert Hsu, editor of China Strategy, argues that the rally in Chinese stocks has further to run despite Beijing's campaign against inflation.    

China's latest official consumer price inflation and producer price index figures came in at the highest numbers in more than two years. Consumer price inflation was up 4.4% from the same period last year, driven by a 10.1% rise in food prices, and the producer price index, a leading indicator of inflation, was up 5%. The Chinese economy is red hot, and the boom is spreading.

Elsewhere in Asia outside of Japan, inflation is also climbing as the region posts a strong recovery from the global financial crisis. Strong Chinese equipment and luxury-car purchases, as well as a weakened euro, have helped Germany bounce back nicely from its downturn. And in parts of resource-rich Latin America, a new boom led by Brazil is taking place as Chinese commodity demand continues to drive the price of agricultural and natural resources higher.

Unfortunately, though, even as much of the rest of the world enjoys a strong economic recovery and has to deal with rising inflation, America has a different set of problems.

The Federal Reserve's plans [for] quantitative easing via the purchase of $600 billion in longer-term Treasuries [weren't] exactly well-received in China, as officials there said the influx of so-called "hot money" would cause global inflation, as well as a shock to the stability of global financial markets.

China's latest inflation numbers show that this concern is legitimate, and the Fed's action will almost certainly spark further inflation globally. The Fed has the power to increase money supply, but it has little control over where the money will go. By buying more bonds, the Fed will continue driving the value of the US dollar lower, and that is almost certainly going to cause commodity and financial asset price inflation around the globe.

I don't think that the inflation in China will necessarily affect domestic consumption, as wages there are also rising by 8% to 10% per year on average. China can also allow the yuan to appreciate faster to dampen the impact of inflation. The wage increase and currency appreciation will offset much of the impact of inflation on domestic demand. Nevertheless, there is the potential here to become a problem down the line.

To combat what is likely to be a spike in inflation, government officials ordered China's major lenders to put up more cash at the central bank. China's reserve requirement ratio for banks will rise by half a percentage point starting next week—meaning that the biggest banks in China are putting aside a record up to 18% in reserves.

The government also took measures to further crack down on speculative hot-money inflows.

However, I think that despite China's efforts, the nation will continue to see asset price inflation. More importantly, I think the world will continue to see commodity and financial asset prices rise.

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