Chinese central bank still turning in favor of higher rates

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Last month witnessed many reports showing Chinese inflation rates near their historical highs. As the “basket of currencies” that maintains much of the renminbi’s worth came to correct, the central bank has had to step up the money supply to keep a low yuan. The main driver behind China’s growing manufacturing centers is the difference between its currency and the rest of the world. To maintain a healthy trade balance, the Chinese central bank has kept the yuan low in value.

Basket of currencies

Now that the currency’s value is not set by the government, but rather its worth against many currencies around the world, the Yuan has appreciated much faster than expected. This has slowed the manufacturing industry in China, which now has to compete with other nations. Prior to the revaluation of the currency, there were few countries that could produce as cheaply and efficiently as China.

Zhou Xiaochaun, the head of the Chinese central bank, has issued statements regarding Chinese inflation. He said that the continued use of higher rates is what will eventually keep inflation low, fighting off a twelve year high. The central bank has also heightened reserve requirements in an effort to take credit and currency out of the economy to keep inflation in check.

Deflation and inflation

The inflationary factors account for more than just a number. A rapidly inflating currency makes the Chinese economic outlook seem great on paper, but when a correction does come, the downturn is more drawn out. The Chinese central bankers may be learning a thing or two from Japan, which had a huge inflation problem in the 1990s and has since slowed in growth. Now Japan is forced keep rates low to jump start their economy.

Maintaining growth is difficult to do when the central bank moves towards deflation. A dropping money supply does increase the value of currency, but will appear as though the overall value of Chinese investments is dropping.

Case in point:

If Toyota makes a profit of 8 billion yuan, a 10% deflation rate would take that value to 7.2 billion yuan the next year, even if the company sells just as many cars. On a number by number basis, it would appear that Toyota is 10% less profitable than it was the year earlier, even with a money supply that is 10% smaller. This sends investors to sell off Chinese securities and ultimately push prices down for shares. Deflation is good in theory, but wreaks havoc in the real world.

Raising interest rates in China also attracts unwanted capital. As rates are lowered around the world, particularly in the United States, China faces more overseas investment. Lower rates in the United States send even more US dollars to a nation that already holds $1.68 Trillion in foreign currencies. At this point, it seems as though the Chinese treasury is filled with cash.

Trade surplus

China operates with a $262 Billion trade surplus, which continues to pump foreign currency into its reserves. Because the yuan is also backed by its reserves, the value of the yuan is rising, while currencies around the world drop. If this cycle continues, China could lose much of its manufacturing business to producers overseas. High fuel prices have also hurt the exporting nation, as it is now much cheaper to produce bulkier items near the point of sale. Transporting goods from China to the United States, its largest trading partner, gives the nation a severe disadvantage in pricing and availability of products.

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