China’s prescribed solution to its inflation problem is not working, which not only hurts the nation’s already sputtering economy, but also adversely impacts developed economies like the US and others.
There are plenty of risks out there to keep markets nervous right now. Two of the most visible are Europe in the short term, and China over the next six to 12 months.
China’s unsound monetary policy is causing problems.
Sure, the economy is booming—it grew 9.5% in the second quarter, which was better than expected—but with such low interest rates and banks still willing to lend, it should be booming.
The problem is the country’s foreign exchange (FX) reserves, which continue to soar.
China’s reserves increased $153 billion in the second quarter after jumping nearly $200 billion in the first quarter. China’s total FX reserves now stand at $3.2 trillion, equivalent to around 50% of GDP.
This is not a sign of strength, but of severe economic distortions.
As the Financial Times says:
“China must print renminbi to buy all the foreign exchange streaming into the country. To blunt the inflationary impact, it issues bonds and orders banks to set aside a chunk of their deposits as required reserves, but economists say that room for such sterilization operations is increasingly limited. That could put currency appreciation back to the forefront of efforts to damp down on inflation.”
China has an inflation problem.
This is because of its extraordinarily loose monetary policy. But it has been reluctant to do what’s necessary to control inflation. Instead, it increases reserve requirements and slowly increases interest rates. As you can see from this chart, these moves have little impact on the problem.
China’s inflation is primarily a result of it wanting to maintain a cheap currency.
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