Rising inflation may force China to let currency appreciate

The fuming customers at Chaoyangmen Food Market in Beijing might help accomplish what senior U.S. officials and manufacturers have been unable to do: persuade China to strengthen a weak currency that has kept its exports cheap, but is fueling inflation at home.

Rising prices for food, fuel and housing have led to China's worst inflation in more than two years. Growing discontent among ordinary Chinese has the central government scrambling to cushion the fallout from the nation's booming economy.

"Prices are going up a lot and it's getting very difficult," said Wei Shuping, 60, inside the frosty Chaoyangmen market where she perused stands piled high with cabbage, turnips and carrots. "I can't believe what I'm paying for potatoes. And things are only going to get more expensive during Chinese New Year" next month.

China's leaders have taken anti-inflationary measures, including raising interest rates and applying old-fashioned price controls. Chinese President Hu Jintao this weekend expressed confidence that China can control inflation and said it wouldn't get out of hand. Hu will arrive Tuesday for his first state visit to the U.S.

But so far Beijing's policies haven't tamped down prices, nor quelled frustration that has sometimes turned violent. Now, some economists say, Chinese leaders may have little choice but to allow the yuan to appreciate at a faster pace against the dollar.

A stronger yuan would make imported food and foreign-made goods less expensive for Chinese buyers, helping to curb inflation. Yet Chinese officials have been reluctant to deviate from the nation's weak currency policy. In written responses to questions from the Washington Post and the Wall Street Journal, Hu showed no indication that China intended to waver from that path.

That strategy has kept China's goods cheap for overseas buyers and helped create millions of factory jobs. But it has stirred resentment from the U.S. and other trading partners who complain that a weak yuan gives China an unfair advantage. President Obama is certain to voice concerns about the yuan when he meets with Hu.

China's yuan has risen about 3.5% against the dollar since June. That's far short of the 20% or more that some American officials are demanding to help U.S. manufacturers.

But Chinese leaders are more concerned about their own disaffected citizens.

In November, thousands of students in Liupanshui, a city in southern Guizhou province, ransacked their high school cafeteria, smashing windows and tossing benches after the prices of bottled water, bread and rice were raised a few cents, the People's Daily reported. The day after Christmas, China's premier, Wen Jiabao, took to the radio airwaves to offer sympathy to those struggling to make ends meet.

"What you said has hurt me," Wen said after a caller spoke of being stressed by prices. The premier assured listeners that the government would control inflation.

China's consumer price index — the main gauge of inflation — hit a 28-month high in November at 5.1%. Experts say the increase is actually much higher.

China's leaders are acutely aware of the threat inflation poses to social stability. The deadly 1989 protest in Beijing's Tiananmen Square was held against a backdrop of soaring prices and economic discontent. Forty years earlier, the Communists defeated a Nationalist government crippled by hyperinflation.

China's inflation problem is partly an offshoot of its currency policy. The nation's rapid growth and huge trade surpluses continue to attract massive amounts of foreign currency into the Chinese economy. China's central bank buys it and replaces it with yuan to ensure the exchange rate remains favorable to domestic producers.

Ordinarily, much of the currency created would be held in reserves by China's banks. But that changed after the global financial crisis, when state-owned banks went on a lending binge to keep China's economy humming. China's money supply increased more than 50% during that two-year period, leading to an investment-driven recovery that probably catapulted the country past Japan for good as the world's second-largest economy.

The trade-off has been a flow of easy money into investments such as real estate. Soaring property prices have stoked fears of a bust and created a housing affordability crisis. Wages and the prices of everyday necessities such as cooking oil and cabbage are also being pushed upward.

A stronger yuan would help tame inflation by slowing flows of foreign currency into the country. But Hu's comments suggest Chinese leaders may blame U.S. policies for devaluing the dollar and stoking inflation abroad. And analysts said Beijing also doesn't want to appear as if it's caving in to the United States.

Chinese leaders "have to keep a balance to accommodate the outside world and the world inside China," said Jin Canrong, dean of international relations at China's Renmin University. "It's a double bargaining process."

Inside China, some business leaders — such as importers of commodities and staple food products — have spoken about how a stronger yuan could help the Chinese economy. Buying foreign raw materials would be cheaper, consumers would command more purchasing power and banks would have more freedom to set interest rates, they say. Similar pronouncements have been made by some government officials.

But there are risks as well. Beijing leaders are fearful that a rapid appreciation of the yuan could destabilize China's export sector and leave millions out of work. That could mean trouble for the global economy too.

"If the appreciation is too fast it will put a shock to the Chinese economy, which in turn will affect the rest of Asia," said Peter Wang, chief executive of City of Industry-based America Chung Nam Inc., the largest wastepaper exporter in the U.S. "And the negative impact will then ripple out to the rest of the world."

The stakes are high with the rest of the world increasingly looking to China to lead the global recovery, and the nation's Communist government pinning its legitimacy to robust economic growth.

Although hiking interest rates and bank reserve requirements could spell temporary relief, experts say inflationary pressure will not dissipate until China can resolve its high trade surplus that's flooding the country with cash.

"It's like trying to dry yourself off with a towel under a running shower," said Patrick Chovanec, an economics professor at Tsinghua University in Beijing. "You need to turn the faucet off."