by Richard J. Grant
The Chinese were in a position similar to that of the Germans 50 years earlier. In 1960 the German mark had a fixed exchange rate with the US dollar which, in turn, was officially fixed to gold. But as the US began the inflation that would ultimately lead to its break with gold, it transmitted that inflation to all those currencies, such as the mark, that were fixed to the dollar.
During 2010, the Chinese consumer-price inflation rate was rising. It peaked out at 6.5 percent in mid-2011. That was a year after the Chinese released the yuan from its dollar peg in June 2010 when its managed appreciation began. With this, and higher bank reserve requirements, inflation has dropped to 3.2 percent year-on-year for February.
In the past year, the yuan has appreciated about 4.4 percent against the dollar and 9 percent against the euro. Not surprisingly, Chinese trade surpluses have diminished. In February, their trade balance with the rest of the world went into deficit.
Last week, Chinese Premier Wen Jiabao announced his government's 2012 “growth target” of 7.5 percent, down from 8 percent. Such projections usually understate their true expectations, but the reduced target is consistent with deliberate currency strengthening. The pegged exchange rate required the regular purchase of a large quantity of dollars and the issue of a commensurately large quantity of newly created yuan. The reduction of such monetary inflation generally results in a slowdown and the temptation to reflate.
The premier's justification of the diminished growth target seemed to recognize that the continuation of such inflationary stimulus might possibly result in a worse slowdown. He said a reduction would help improve the quality of growth and better facilitate a needed economic restructuring. The implicit hint is that inflation and fiscal stimulus can yield a low-quality growth that is unsustainable.
Just as the economic gains of the past 30 years were made possible by a relaxation of the communist chokehold, future gains will depend increasingly on further deregulation and extension of property rights. Premier Wen spoke of the need to improve the security of rural land rights and the need to deregulate the financial sector by finding a way to legalize what is now an underground finance market.
The extension and clarification of land rights would enable more productive use of that land and make it available as collateral to attract financing. Deregulation of the financial sector would open up opportunities currently ignored in a marketplace dominated by large state-owned banks.
A less-regulated economy always adjusts more quickly to the after effects of inflation. As in any economy, the real limits to growth and adjustment are legal, not physical. The economy will continue to grow as long as the state continues its evolution from a restrictor of private action to a protector of private property rights.
Any hesitation in this evolution will make the prospect of any “hard landing” that much harder to take.