Fighting Chinese Inflation

We have previously discussed the cause of the inflationary threat in China (click here for blog). This week, we have pulled together some news article showing some of the policy options that are available to countries that are trying to fight inflation. All of the articles apply to China.

The first line of defense is usually to increase interest rates. As rates rise, borrowing gets more expensive so construction costs rise, the demand for durable goods falls and the net present value of investment options decreases. All of these serve to reduce domestic demand and reduce inflationary pressure. A Reuters article dated Feb 8, 2011 explains that China has exercised this option raising their lending rate for the second time in the last seven weeks. Unfortunately the savings rate, at 3% is below the inflation rate of 5.3%. The real interest rate on savings is negative which creates a disincentive to save and an incentive to spend which is counterproductive to the policy goal. This effect is discussed in a Feb 9th Bloomberg article.

A second method that is available to some countries is to increase the reserve requirement. Reserves are funds that are held by banks against deposits and in some countries this rate is dictated by the regulatory authorities. Canada has no required reserves. China does, and a CNNMoney.com article indicates that that ratio has been increased to 19% for major banks. The effect of this is to reduce the supply of loanable funds in the market place, reducing liquidity and slowing the growth of credit.

China has adopted yet a third measure to try and control its inflation. A BusinessWeek article dated Jan 9, 2011 indicates that Chinese banks are being required to increase their capital ratios. (Capital divided by assets) An increase in capital ratios reduces the amount of funds that are available for lending, which gives the same results as increasing the interest rate or the reserve requirement.

China’s monetary authority is trying every tool available to it, except for one. The inflation in China is being caused largely by their policy of having the yuan pegged to the US dollar at a rate below its equilibrium value. The resulting capital inflows increase the domestic money supply and that is the root cause of the inflation. Let the yuan float and the inflationary pressure will dissipate.