China’s currency problem looks to be growing (Photo: REUTERS)

The only thing that surprises me about China’s spike in inflation is that it took so long to show itself. Some economists had been worried for a while that a combination of rapid growth, giant stimulus, a mammoth credit expansion and the effect of high commodity prices would cause an inflation problem for China. Inflation hit 5.1% in November, the fastest clip since the pre-crisis boom months of 2008. Though much of the increase is in food (up 11.7% from a year earlier), the inflationary pressures are spreading to more aspects of the economy. According to Goldman Sachs, housing-related prices (such as rent, management fees, etc.) rose an annualized 21.6% in November.

Inflation is a serious matter in China, since the still-poor populace gets hit very hard when inflation rises, both due to higher living expenses, but also since it eats into the value of their large savings. Chinese policymakers have been struggling to stamp out inflationary pressures for several months, but without much impact. In part, that’s because they’ve been reluctant to raise interest rates — the usual inflation-fighting tool used by central bankers. Rates have been hiked only once this year. The reasons why show us how tricky a spot China’s government now finds itself in, as a result of unconventional economic policies and political stubbornness.

From the Chinese standpoint, there are likely two big problems with increasing interest rates. First, higher interest rates would attract more money from outside the country, putting even greater pressure on the yuan to appreciate. And China’s policymakers have made clear that a strengthening yuan is not an option. A commentary in a central bank-owned newspaper on Thursday said that maintaining the “basic stability” of the exchange rate was “advantageous.” That’s Chinese government-speak for “the yuan ain’t going nowhere.” By resisting yuan appreciation, the Chinese are also removing yet another tool they could use to fight inflation. (A stronger currency brings down the prices of imports.) Perhaps the Chinese don’t want the yuan to rise because they’re still worried about the competitiveness of their exports amid the weak global recovery. Or their resistance could be a result of its foreign-policy position, an insistence on standing firm against international criticism of its currency regime. The Chinese government insists the yuan is just fine where it is, and it would rather deal with inflation in other ways than concede that the yuan needs to be stronger.

The second problem with interest rate hikes has to do with domestic levels of debt. Over the past two years, China has witnessed an incredible surge in bank lending – a product of government stimulus policies, to hold up growth during the global downturn. That surge built up debt levels at Chinese companies and local governments. By hiking interest rates, the central bank would be increasing the interest burden on borrowers. That, in turn, could intensify a bad loan problem at China’s banks that many economists believe is an inevitable result of the lending boom.

So instead of raising rates, officials have tried to curtail the lending to squelch inflation by raising the reserve requirement at the banks – in other words, forcing the banks keep more money parked at home, which reins in the amount of loans they can issue. Last Friday, that rate was raised for the sixth time this year, to an all-time high. But the impact has been somewhat limited. The number of new loans made this year will likely bust through the government’s target of $1.1 trillion for 2010. In a recent report, Fitch analysts figured that lending in China is in reality much higher than even that, because the banking sector has found ways of artificially reducing their loan holdings, by, for example, turning them into off-balance sheet wealth-management investments. (Sound familiar?) If credit growth roars on, the Chinese central bank will have a lot of trouble controlling inflation.

So the Chinese have instead turned to an old favorite, price controls on certain staple foods. Perhaps China’s mix of reserve ratio increases and price suppression will eventually come to control inflation, but there seems to be consensus among economists that these methods won’t be sufficient, and that the central bank will eventually have to turn to the traditional method of rate hikes, perhaps even implementing one before the end of the year.

Higher interest rates will knock over all of the other dominoes in China’s economy. The government will have to intervene even more drastically in currency markets to restrain the yuan from strengthening. Companies, both state and private, government entities and consumers will be pinched by higher debt payments. The impact will likely be moderate at first, since economists don’t expect China’s central bank to raise rates too sharply. Instead, China’s policymakers will try to use those alternative methods – especially reserve ratio increases – to control inflation. But if that doesn’t work, we’ll be looking at more rate increases, and more fallout for the economy.

Having used unconventional policies during the downturn – government-induced bank lending and exchange rate manipulation – China is stuck with unconventional methods of inflation fighting. It’s interesting times for the policy gurus in Beijing.