By: Dr. Mike Campbell

China saw a year-on-year inflation rate of 6.5% for July. This increase in the annual inflation rate has occurred despite five interventions by the Chinese central bank to raise interest rates since October 2010. Interest rate policy is one of the most important tools in a central bank’s armoury to fight inflation. The idea is that by increasing interest rates, the cost of borrowing is increased, reining in the money supply and stifling demand which, in turn, causes prices to stabilise or drop back.

Whilst China overtook Japan last year to become the world’s second largest economy behind the USA, many of its citizens have yet to experience any personal benefits from the nation’s improved financial circumstances. Consequently, rising prices for the basic necessities of life is an increasingly hot topic in the communist nation. Unsurprisingly, the Chinese government has stated that controlling prices is its top priority. The central bank has also tried (with limited success) to curb the amount of money available for borrowing by insisting that banks increase the liquidity (cash) that they hold in reserve.

Under normal circumstances, higher interest rates would lead to increased demand for a (major) currency, but few analysts outside of The People’s Republic believe that the Chinese Yuan is allowed to respond to market forces. Indeed, the Chinese have complained loudly that the American Dollar is being allowed to depreciate which, of course, devalues the very large holdings that they have of US government bonds.

It is likely that the current turmoil on world markets which has been inspired by twin fears of widespread sovereign debt problems and a slowdown in the global economy will drive down demand for Chinese exports. This will give China a headache as it tries to tackle the problem of price control without stifling demand both internally and abroad for her goods.