China Inflation Thoughts

Interesting article in the WSJ today about growing inflationary pressures in China. Inflation has been accelerating in the country, rising above 5% despite the government's efforts to slow price increases. The one-year lending rate now stands around 5.8% and the government has repeatedly increased the reserve requirements for banks in an effort to slow growth. Stoking inflation is rising commodity prices, which the country imports in large quantities, and an effort to raise wages to spur domestic consumption. The minimum wage in Beijing increased 21% last month after a 20% increase in June.  The government is also resorting to price controls in order to offset rising prices however, this action hurts producers exposed to rising costs.

My takeaway is that pressure continues to build to allow the yuan to increase relative to the dollar, which will eventually be loosened. The government worries about "hot money" rushing into the country in anticipation of a rising yuan, but the longer they delay the more pressure is likely to build. The question becomes whether this ends happily with Chinese inflation abating while the economy continues to grow, or badly with hot money over-heating the economy before a spectacular crash that likely takes down the world economy. In my opinion, they would be smarter to start chipping away at the obvious imbalance now before it overwhelms their ability to cope with it.

Under my sagflation theme, I argue that price bubbles are likely to occur due to the U.S. government's aggressive monetary policies. Since the Chinese are keeping the yuan artificially low relative to the dollar, they are in essence importing our expansionary monetary policies. It is a little scary to think an entire country the size of China could become a bubble, but I believe that is likely what will happen over the next year. How to play this bubble is going to be challenging since the Chinese government could allow the yuan to rise, increase interest rates, or some other centrally controlled effort to tamp down prices. So far, I'm betting the government lets the good times roll any way possible, which means encouraging domestic consumption and trying to actively manage prices through controls. These policies should make my investments in CHOP and EDS perform well, but when to get off the train will be a critical decision.