By Hui Zhong
We all know the living standard in China, denoted by increased incomes and savings, is quickly diluted by its high inflation, especially for the food prices. The inflation is always associated with over printing by the Chinese Central Bank. But why can the Chinese Central Bank not slow down their printing?
First of all, we should understand why the Chinese Central Bank needs to print money all the time. China is a trade surplus country but its currency, the Chinese Yuan, can not exchange for other hard currency without limits like the U.S. dollar. So when the Chinese accumulate more and more dollars each year by trading their goods manufactured by their factories, they have to change those dollars for the Chinese Yuan only because the dollar can not be circulated and used to buy anything directly in the chinese market. When those money in dollar turns to the chinese yuan, the Chinese Central Bank actually prints the yuan and uses it to exchange for the dollars which we define it as foreign exchange reserve. We should know the reserve itself is not frozen money, it indeed has been circulated in China by printing its “equivalent” amount of Chinese Yuan into the market. That “equivalent” amount of Yuan should be backed by the Chinese production capacity. In another word, any printed Yuan should have right to change for the chinese produced goods without increased prices. Otherwise, if more money pursue the limited goods, it will cause inflation as the consequence of the over printing. The foreign exchange reserve held by the Chinese government will be used when the Chinese companies import goods from other countries by changing their Yuan in hand for the dollars. In this case, the amount of Chinese Yuan and the U.S. dollars in the reserve is reduced by the same amount and as a result, the decreased money turns to the goods produced by foreign countries.
The problem is what is the “equivalent” amount of Yuan for each Dollar. If the exchange rate is too high, the central bank actually over prints the Chinese Yuan into the market that can not be backed by the Chinese production ability. Then inflation will be resulted. So the distorted high exchange rate, right now at 6.6 Yuan per Dollar, is the fundamental reason for the inflation in China. A lower exchange rate, for example at 5 Yuan per Dollar, will cure the over printing problem and is the only way to cool down the inflation in China in my opinion.
China may want to keep its trade advantage with a higher exchange rate. But by introducing an unintentional high inflation, the businesses there have to pay more production costs. As the results, their competition edges gained by its high exchange rate are effectively neutralized by its high inflation caused by the same reason that builds their competition advantages at the first place.