Interest Rates, Currency Values, and Inflation

Producer prices in China have risen 3.5 percent more in January, 2004 than they did over the same period a year ago. Prices had risen 1.9 percent in November and 3 percent in December, 2003, placing continuing pressure on policy makers to respond. The China Daily recently cited three Chinese economists who said that "there is a possibility that China might raise interest rates this year to counter continually rising consumer prices and investment growth." A central bank representative responded by saying no rate increase was planned.

These two opposing positions on the subject of interest rates underline the growing debate in China over the seriousness of possible inflation. The deflation that China has been experiencing appears to have ended as the consumer price index in China rose at an annual rate of 3.2 percent in January, marking a second consecutive month of inflationary tendencies.

Hong Liang, an economist at Goldman, Sachs, said in a research report that sharp increases in the price of food, by far the biggest single component of China's consumer price index, "is reflective of rising inflation expectations."

China is determined to keep the yuan from appreciating against the dollar in currency markets, even as foreign investment continues to pour into the Chinese economy. China prevents the appreciation by issuing yuan to buy dollars and keep the yuan pegged at 8.2 to the U.S. dollar. This policy is placing further pressure on domestic prices.

One solution to the inflation problem is tighter monetary policy. Tight money would result in higher interest rates, less spending in the economy, and a lowering of inflationary pressures. Alternatively, the government could allow an increase in the value of the yuan, which normally happens in a growing economy. This would reduce inflationary pressures further. Government officials have recently hinted at the prospect of allowing small adjustments to the currency's value, suggesting that they wanted exchange rates to be "rational" and "basically stable" without reaffirming the 8.2 peg to the dollar.
Regardless of the final solution, which may be a combination of several policies, the current evidence suggests that China is in danger of experiencing some severe inflation.

(Updated April, 2004)