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Once again, China was plastered all over the forex headlines yesterday, as a report indicated that Chinese GDP grew by 9.8% during the fourth quarter of 2010. On the strength of rock solid industrial production (13.5% y/y) and retail sales (19.1% y/y) figures, the report blew past the predicted 9.4% expectation that many experts forecasted. This put Chinese GDP growth for 2010 at a Whopper-sized 10.3%.

And of course, all this did was spark speculation that the People’s Bank of China will continue to raise rates. If you read my article earlier this week on why China keeps on hiking rates, you’d know that inflation is starting to become a real problem. Over November and December, inflation printed at 5.1% and 4.8% respectively, while some are predicting it could hit as high as 6.0% in 2011! Holy smokes, China-man – your utility belt is on fire!

China CPI 2010

To counter this rise, Chinese officials have been making some moves, most notably through increases in the base interest rate and reserve requirement ratio.

The question is, will this be enough?

While raising the reserve requirement ratio would drain excess liquidity (therefore, making less money available for lending) and increasing interest rates would make borrowing more expensive, it does run the risk of a surge of “hot money” entering the Chinese economy.

The problem with higher interest rates is that it could cause foreign investors to pour their money into China, and it could eventually expose Chinese markets to the creation of asset bubbles. Anyone remember the Asian financial crisis? Oh wait, I think everybody just decided to forget that ever happened…

“So Mr. Gump, you’re saying that China SHOULDN’T raise rates???”

No, not exactly. There are a couple of creative monetary policy moves that the Chinese government could pull off that could help their situation.

First, they could continue to raise interest rates, but they should combine this with a tax on foreign investments. Similar to what Brazil is doing, introducing a tax on foreign purchases could help stem off a flood of hot money coming in. If there’s one thing that foreign investors hate, it’s paying ridiculous amounts of tax!

Second, a more bold approach is… wait for it… (looks around for any suspicious looking people)… to let the yuan appreciate in value.

Yes, yes, I know that China is notorious for keeping the value of the yuan low, but the way things are going, this may be the creative response necessary to help slow down growth, and in turn, fight off inflation. By letting the yuan appreciate, it would put a damper on China’s export industries, which could help cool off the economy a bit.

Yes, it’s a long shot, but it’s still an idea–a bold one at that! For one, it could also help China-U.S. relations. What better way to boost its image as a team player of the Global Recovery team by playing nice with its teammates? Furthermore, letting the yuan appreciate would also ease concerns that a currency war is brewing in 2011.

In any case, it’ll be interesting to see how this all plays out over the year. China is now the second largest economy in the world and potentially holds the fate of some economies (Australia and Japan anyone?) in its hands. Let’s see if it cracks under the pressure, or handles it like a well-oiled machine.