China's Complex Inflation Problem

NEW YORK (TheStreet) -- The Chinese government and a chorus of US critics have criticized Federal Reserve Chairman Ben S. Bernanke's "quantitative easing" (QE2) program since its announcement last November as a direct cause of white-hot commodity inflation.

According to this view, Bernanke unfairly unleashed inflationary forces which China and other countries have to grapple with.

Bernanke has correctly pointed out that China and others could very quickly lessen the effect of U.S. policy by de-pegging their currencies, like the yuan, to the U.S. dollar.

Hedge fund manager Paul Tudor Jones went so far recently in an investor letter as stating the U.S. should force a de-pegging, as it was adding an extra 4% to the U.S. unemployment rate.

In the letter, Tudor Jones discussed the downside to China of their "unsustainable" policy: "one way or the other, the real U.S. and Chinese exchange rate will find equilibrium -- either through nominal movement or through relative inflation rates." He would say we're seeing the latter today.

While I agree that de-pegging the yuan from the dollar would be the single most effective move the Chinese government could make to curb inflation in China, they are unlikely to do so. Even if they did, more action would be needed to quell it.

Over the last 10 years, especially since the 2008 crash, the Chinese government has taken several actions which, although correct at the time, have fanned the price of commodities more so than QE2. Such moves include:

• The 2008 stimulus package that pumped $584 billion into the Chinese economy. In 2010, China's M2 money supply rose 19.7% over the prior year. With money supply now at 73 trillion yuan, it is larger than China's GDP of 67.5 trillion . By comparison, the U.S. M2 as a percentage of GDP is close to 0.6. That will create some inflation.
• For many years, the Chinese government has artificially kept prices of electricity, water, and natural gas low through subsidies to promote economic development. Unfortunately, this has promoted waste by end users and was expensive to the government. Last year, they increased these prices to true market levels. This came as a shock to many and added to perceptions of greater inflation.
• To deal with an over-heated high- and middle-end housing problem in coastal cities last year, the Chinese government implemented a number of draconian macroeconomic policies. They've worked as hot money has been taken out of the housing sector. Yet, evidence exists that speculation and hoarding has flowed into food items such as onions, beans, peanut oil, corn, ginger, apples, and sugar. Food CPI increased by almost 12% last year, which contributed to two-thirds of the overall increase in the Chinese CPI.
• The Chinese government has been trying to migrate the Chinese economy from one driven by foreign exports to domestic consumption. This is seen as more stable and less vulnerable to some foreign Lehman-like shock in the future.

  The government's efforts have been successful. Last year, Chinese consumer spending increased 18.4% to 154 trillion yuan from the prior year. Yet, such consumption doesn't occur without requiring more raw materials to build televisions and appliances. It's a big reason why -- in the last year -- cotton was up 88%, wheat 54%, sugar 38%, and copper 21%.

• The migration of many rural workers to bigger cities to pursue higher standards of living have resulted in stories of "empty villages" back in the country with insufficient labor to grow the needed crops. Lower agricultural demand in turn drives up prices. China has been a net importer of food for many years already. As purchasing power increases in the coming years, the Chinese desire to feed themselves a higher protein diet will further exacerbate prices.
• With an expectation that the yuan will need to be revalued upwards in the coming years and with China's relative outperformance in the global economy, hot money continues to flow into China . That creates additional inflationary pressures.

Beyond these factors, 2010 saw sand storms in Inner Mongolia, droughts in Southwest China, an earthquake in Central China, floods in Hainan Island, and drought, fires and floods in Russia and Pakistan. All these kept an upward pressure on Chinese commodity pricing.

So, while none of these actions by the Chinese government was wrong at the time, it's clear they now have a difficult balancing act of keeping their foot on the gas to drive economic growth will tamping down inflation.

Simply de-pegging the yuan from the dollar won't eliminate all inflationary forces bubbling at the moment. However, the Chinese government would benefit in the long run more from a more rapid increase in the valuation of the yuan than their current go-slow approach. There will continue to need to be increased interest rate and reserve requirement hikes to help moderate the economy.