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25 Million Reasons China Cannot Fight Inflation

Flag of the People's Republic of China
Eriko Koga | The Image Bank | Getty Images
Flag of the People's Republic of China

China today once again raised banks’ reserve requirements in an effort to restrain rising prices. This marks the fifth time this year that China has hiked bank reserve requirements.

If the definition of insanity is doing the same thing time and time again while expecting different results, China's inflation policy is officially insane.

The first four hikes in reserve requirements did not work. Prices in China still rose in April faster than state economists predicted. Bank lending rose faster. Consumer prices were up 5% for a second month in a row.

But this time China—and a lot of gullible people outside of China—are convinced raising reserve requirements will work.

Why isn't the process working? The reason is that the top priority of Chinese government officials is not really fighting inflation—it's creating jobs. China's leadership aims to create 25 million jobs a year because it fears that unemployment could be politically destabilizing.

In order to maintain the pace of job creation, the Chinese government engages in all manner of chicanery, most of which have short term benefits but are economically destructive in the long term.

The most destructive, of course, is China's currency peg. The Chinese government sets the exchange rate for its currency against the dollar, rather than let rates float according to supply and demand. This keeps Chinese exports cheap, which creates jobs in Chinese manufacturing.

But the way China keeps the peg in place is inflationary. The central bank goes into the market and buys dollars, replacing them with yuan.

In other words, the currency peg is kept in place by the government printing press. This cannot help but create inflation.

This creates a vicious cycle. China's currency peg helps its manufacturers export more, which brings in more foreign currency, which requires more monetary inflation to combat yuan appreciation.

This is a monetary treadmill to inflationary hell.

That target of 25 million jobs a year is the reason China cannot effectively fight inflation.

The demand for gold in China has exploded in the first half of this year, no doubt because sophisticated Chinese investors—many of whom have deep connections to the government—understand that as long as the currency peg is in place, China won't be able to effectively fight inflation. Prices will rise, assets bubbles will form, investments decisions will be distorted, until the policy of monetary expansion stops.

China's leaders have been allowing the yuan to appreciate against the dollar. Currently, you can get 6.5 yuan for each dollar—a level not seen since 1993. But this level is still inflationary, which is why prices keep going up in China.

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