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Just last month, China announced that annual inflation soared to its highest level in three years. From a 5.5% year-over-year increase in May, their annual CPI reading jumped to 6.4% the following month, way beyond the Chinese government’s target of 4% annual inflation.

To think that the ECB was scrambling to hike interest rates when their annual CPI reached 2.7%. Compared to China’s, that’s peanuts! Why isn’t the People’s Bank of China (PBoC) panicking yet?

Well, to be fair to the Chinese central bank, they already made several attempts to tame inflation. They hiked their benchmark rate THREE times and increased their reserve ratio SIX times during the first half of the year. Apparently, the International Monetary Fund (IMF) thinks this still isn’t good enough.

In its annual review of China’s economy, IMF directors pointed out that China needs to implement even more rate hikes. Currently, their benchmark rate sits at a lofty 6.56% while their reserve ratio is at an eye-popping 21.5%. How much higher can China go?

The good news is that the IMF expects price levels in China to reach their peak in the coming months then start cooling down to an average reading of 4.7% for the entire year. Furthermore, they predicted that annual CPI will fall within the government’s target and stabilize at 3.3% in 2012. According to the IMF’s number-crunching, just one or two rate hikes could be enough to do the trick. Phew!

The bad news is that the IMF also warned that China faces the risk of a property bubble and a decline in credit quality. As I discussed in my article about the sore spots that China should keep an eye on, higher interest rates make it more expensive for the Chinese to secure housing loans. Combine this with the oversupply of real estate properties in the nation and China’s got a property bubble ready to burst.

So how can China keep inflation contained while avoiding a real estate bubble at the same time? If the PBoC simply continues with its aggressive tightening moves, sky-high interest rates could further discourage people from acquiring properties. On the other hand, if the PBoC just sits on its hands, inflation could spin out of control. What’s a central bank to do now?

Lucky for them, the IMF has a suggestion up its sleeve. They reminded China that a strong currency could help them hit two birds with one stone.

This isn’t something we’ve never heard before. The IMF, along with other nations (ahem, the U.S.!), has been pressuring China to adopt a looser exchange rate policy in order to help rebalance the global economy. As it turns out, a stronger yuan would also work for China’s own good.

If you’ve been paying attention in your Economics 101 classes, you’d know that a stronger domestic currency makes imports cheaper for both local consumers and producers. Since this enables individuals to buy goods from other countries at a cheaper price and companies to pay lower costs for raw materials, inflation is effectively contained.

Magician and top hat

With that, the PBoC could decide that further increases in interest rates are no longer necessary and may even start thinking about normalizing their monetary policy. As borrowing rates start to stabilize with less chance of rate hikes on the horizon, it would encourage the Chinese to secure loans to finance their real estate purchases.

*POOF!* Property bubble no more, and inflation is subdued. Tada!

As awesome as this solution sounds, it didn’t receive a nice warm welcome from China. Not even the Chinese representative at the IMF, Jinxiong He, is happy about being nagged to go for a looser exchange rate regime in China. According to him, the excessive quantitative easing in the U.S. is to blame for the entire inflationary mess and that the IMF should give China a break.

*POOF!* There goes our hopes of seeing a stronger yuan.

This also implies that China is left with no choice but to rely on the PBoC’s rate hikes to cool inflation. Another rate hike or two before the end of the year, as the IMF prescribes, might not be so bad. But if the PBoC gets trigger-happy with its hikes for the rest of 2011, the world’s second largest economy might be in big trouble!