China’s Dilemma

In order to sustain a growing economy during one of the worst global recessions in history, Chinese officials approved a massive stimulus package that dwarfed that of the US in terms of percent to GDP. This stimulus package was administered very effectively due to the government’s control of the banking system. Thus far, it has fulfilled its purpose and has produced envious GDP growth rates and worldwide acclaim. However, like any other program that tinkers with economic growth, unintended consequences have resulted. Inflation has begun to lurk and has produced a fork in the road for policy-makers. They have two main options:  continue loose monetary policy and look the other way or combat inflation by raising rates and/or letting the yuan strengthen.

I believe that continuing loose monetary policy is not an option at all. Pursuing this would result in depletion of rural savings, as well as a higher cost of living for essential items such as food and energy. For a government that seeks to maintain control of its country at all costs, it would effectively be shooting itself in the foot. Continued increases in inflation would result in higher crime, more riots, and an overall destabilization of the Chinese government system. China’s rural population is so vast that any government would be hard-pressed to subdue it were it to get unruly.

The other option would be to combat inflation by letting the Yuan appreciate and/or raising rates. Letting the Yuan appreciate would increase domestic purchasing power (consumption), subdue inflation, and improve exports for foreign countries such as the US, Japan, and Europe. Unfortunately, China has just been named the largest exporter in the world. It is very unlikely that domestic consumption alone can carry this one trick pony. Yuan appreciation would create a substantial headwind for exporters, which at a time of weak global aggregate demand and thin exporters profit margins, could prove disastrous for the economy in general. The other option entails raising interest rates, but this has its own unintended consequences. Raising rates could pop a potential bubble in the real estate market or induce the incentive to save.

Ironically, it is now China that must decide between its upper and lower class. The US and Europe have made their decisions. They have committed taxpayer money to bail out imprudent decisions made by the financial and political elite. While this has led to considerable displeasure in those countries, there haven’t been any major violence demonstrations. I believe that the story for China would be completely different. Pursuing policies that may be construed to support the upper class would lead to immediate violence on a large scale and an unstable situation for the government. Their government may be in a checkmate situation. They must combat inflation. The world will soon find out whether the emperor is wearing any clothes.

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