China could fight inflation by letting money out

November 22, 2010

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

HONG KONG — China is in an inflationary bind. Policymakers need to bring interest rates up, yet are worried about triggering debt defaults and attracting speculative money. Two bank reserve requirement hikes in two weeks, and new measures to stabilise consumer prices, will only have marginal effects on rising prices. A better way would be to let money flow offshore.

China’s inflation is caused by excessive liquidity. The broad money supply (M2) has roughly doubled since 2008 to $10 trillion. Foreign inflows have played a role. The central bank injected the equivalent of $1 trillion into the system just to buy foreign currencies from its citizens. The question is how to let more of that money out.

One way would be to let Chinese investors buy more assets overseas. Citizens have already been allowed to invest $67 billion into foreign equities, 2.5 times more than foreigners can buy in China. Yet Chinese investors aren’t terribly keen. Half of the available foreign-linked investment products trade below their net asset value.

Encouraging businesses to invest more abroad would help too. The United States, for example, might welcome some healthy imported inflation. Outward investment rose 18 times to $56 billion from 2003 to 2009, official figures show. But money tends to go where returns are higher. China accepted 70 percent more foreign direct investment than it gave in 2009.

If the private sector won’t take the lead, the state might. China’s authorities already buy up billions of dollars of foreign government bonds every year. They could mop up domestic liquidity by issuing debt, then use the money to invest abroad. But government investors aren’t always welcome abroad. Exporting yuan for others to buy Chinese goods hasn’t worked either. Beijing has offered to lend billions of yuan to other governments, but most of its currency swaps remain undrawn.

All of these problems share one root: China’s undervalued currency. Domestic investors expect that the yuan will appreciate, which gives them a strong reason to keep money close to home. The market is pricing in a 3 percent increase in the year, relative to the dollar, yuan forwards show. If China wants to fight inflation by letting air out of the balloon, letting the currency rise would be a good start.

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