During 2006 China’s GDP grew by 10.7% vs. 10.4% in 2005. As I have discussed previously, China will continue to experience hyper-growth as long as US consumer spending does not falter. However, this looks like a low probability scenario given that the US housing market, which played a large part in boosting consumer spending during the last 5 years, is clearly in a recession.

Another cause of concern for China’s policy makers is the recent increase in inflation. Although the government reported that inflation increased by only 1.5% during 2006, December saw inflation rising 2.8% year-on-year. It is important to keep in mind that China’s government is similar to the US’ in constructing the CPI as a measure of inflation with a bias to understate. So actual inflation is likely to be even higher.

Asset prices have sky-rocketed as can be seen in the real estate and stock markets. Also, wages are increasing over 10% annually. The one sector which has been immune to inflation is manufactured goods due to increasing capital investments leading to economies of scale. But this can’t go on forever and continued cost savings will most likely end when US consumers reduce purchases of Chinese goods leaving manufacturers with excess capacity.

Rising inflation is inevitable due to China’s current policy of pegging the yuan to the US dollar. This has forced the central bank to recycle export earnings from dollars and other hard currencies into yuan leading to a blowout of the money supply which will eventually cause prices to rise. In December M2 increased by 17% year-on-year, much faster than GDP growth.

The central bank is trying to combat monetary inflation by selling bonds to commercial banks and mopping up some of the liquidity. In the long-run, this is ineffective and actually counter-productive since it will cause an increase in interest rates leading to further foreign capital inflows and monetary expansion.

There is only one way out of the inflation problem for China. The yuan must be allowed to trade more freely at a higher value, which would reduce capital inflows and credit expansion. Intense pressure by Chinese manufacturers, who have benefited from the undervalued yuan, has caused policy makers to contain the rate of the currency’s appreciation.

It is certain that the yuan will trade at a much higher exchange rate against the US dollar and Euro a few years from now. However, it is less certain that the appreciation will occur before China’s inflation gets out of control.