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China's Inflation Pressures Government

BOSTON ( TheStreet) -- China's accelerating inflation may restrain economic growth and strengthen the yuan if the government takes counteractive measures.

China's consumer price index rose 2.7% in February, the fastest pace in 16 months and more than economists' estimates of 2.5%. China's massive economic stimulus has kept the economy purring as global growth has sagged. Quicker inflation makes it more likely that the Chinese government will pull the stimulus early. China could also raise interest rates to slow growth and contain inflation.

Higher interest rates would be one of the worst outcomes for foreign investors, since it would raise the cost of capital in China and make expansion more difficult. While removing the stimulus would be like getting rid of rocket fuel, a rate increase would be more like downshifting.

The Chinese government has been preventing the yuan from increasing in value versus the dollar to make its exports more competitive. The practice, however, prevents the market from operating in its usual fashion, driving up currencies with cheap products to compensate for increased interest in their exports. As a result, Chinese consumer prices are being pushed up by the waves of cash coming in from around the world.

After today's reading on inflation, the Chinese government may be more inclined to allow the yuan to appreciate slightly to try to stamp out inflation. That would be good news for domestic companies that have been hurt by ultra-competitive Chinese exports. If Chinese products become more expensive, retail chains such as Wal-Mart (WMT - Get Report) and Target (TGT - Get Report), two stores obsessed with providing the cheapest products possible, would be more likely to carry American-made goods.

Inflation hurts China's investors. However, for investors outside the country, the possible appreciation of the yuan could add to the rational for investing in Chinese companies. Besides the gains from solid performance, investors would also be compensated for the increase in the yuan versus the dollar.

Chinese companies such as China Automotive Systems (CAAS - Get Report), Shanda Interactive (SNDA) and Jinpan (JST) are attractive vehicles for investors outside China. That country's growth should still be more robust than that of the U.S. even if the stimulus is removed.
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