With China's inflation - and inflation expectations - rising, how can price stability be maintained without threatening the country's booming growth? Reconciling growth and fighting inflation is not impossible, but it does require that the government overcome its deep-seated suspicion of opening China's markets to imports.
The World Bank predicts 3.5 per cent growth for the world economy this year, and most analysts predict that the United States will grow at a similar pace. As a result, external demand for China's exports will be strong, while the interest-rate differential between China and the world's advanced economies is resulting in massive capital inflows. Thus, China will continue to accumulate large foreign-exchange reserves this year.
As a result, the Chinese authorities are now deploying a combination of tools to stabilise domestic prices. With the reserve ratio of banks already at 19.5 per cent and unlikely to be raised by a large margin, interest rates will most likely continue to be raised.
Indeed, the benchmark interest rate reached 7.47 per cent in August 2008, after a five-year climb. Given today's current lending rate of 5.56 per cent, the authorities have a great deal of upside room.
But raising interest rates has its downside: higher capital inflows, which will offset the disinflationary effect of higher borrowing costs. As a result, it is reasonable to expect that Chinese authorities will soon tighten controls on capital flows.
Foreign governments and international markets would like to see China fight inflation by letting the renminbi appreciate in value. To the extent that the renminbi becomes more expensive, appreciation would discourage the influx of foreign capital. But any currency appreciation would also raise peoples' expectations of further appreciation - and thus invite higher capital inflows.
Appreciation will help China's fight against inflation only if it brings down China's trade surplus. But the experience of 2004-2008 suggests that moderate appreciation is not enough. That is why some economists believe that China should take much bolder steps toward allowing the renminbi's exchange rate to strengthen. For Chinese officials, however, this is out of the question, because it would almost certainly cause large-scale unemployment and thus threaten social stability, which is closely tied to the government's legitimacy.
Because the main inflation-fighting tools are double-edged swords, the Chinese authorities are likely to turn to other measures. For one, they will likely introduce quantity controls on bank lending, though the effects of such regulations are diminishing because banks and other financial institutions have developed a range of ways to circumvent them.
A more effective measure is to expand the central bank's sterilisation operations. In theory, the People's Bank of China (PBOC) can sterilise any amount of money supply caused by foreign-capital inflows simply by issuing the requisite amount of bonds. In practice, the PBOC faces two kinds of costs.
The first cost is a direct accounting loss: the interest rate will inevitably increase when more bonds are issued. At the same time, the interest rate paid on the central bank's foreign reserves, mostly in dollar-denominated US Treasuries, is low.
The second cost is implicit, but potentially far more substantial: because sterilisation bonds are forced savings (and deflationary by definition), they absorb the potential investment and consumption implied by today's trade surplus. For example, banks would curtail mortgage lending in response to higher rates paid on sterilisation bonds, forcing consumers to save more in order to buy houses. So more bonds today would deter domestic investment and consumption tomorrow.
Thus, the PBOC's sterilisation operations are likely to be self-defeating in the long run. The bank sterilises the money supply caused by today's trade surplus, but in the meantime causes further current-account surpluses in the future.
So China's authorities must find new ways to address its external-imbalance problem. One way might be to increase consumer imports. Right now, consumer goods account for only 2.3 per cent of China's imports, as they are subject to relatively high tariffs and value-added or sales taxes at customs, where procedures are complicated and slow.
Lowering the tariffs on consumer goods and simplifying customs procedures would improve consumer welfare while causing no significant harm to domestic industry. To see why, consider potential imports from the US, most of which are likely to be brand-name products, furniture, high-end cars, and land-intensive agricultural products (such as beef). China has a comparative advantage in none of these areas.
Unlike exports, higher imports of consumer goods would thus help China combat inflation. Moreover, increased imports would reduce China's trade surplus and help balance China's external position, which would be much welcomed by the international community.
In short, a policy aimed at increasing imports would serve several important goals - and poses little or no risk to economic growth. There is no good reason why the Chinese authorities should reject such an effort.
Yao Yang is Director of the China Center for Economic Reform at
Peking University.
© Project Syndicate