In our previous article, Cause of inflation: Shanghai bubble case study, we explained that the root cause of price inflation is monetary inflation. The Chinese economy is awash with growing liquidity (that is, the economy is soaked with ever-growing supply of money). The next question to ask is: why is money supply growing in China?
One of the culprits for this problem is the inflexible exchange rate of the Chinese currency (RMB). The RMB is not a freely floating currency?its exchange rate is still controlled by the Chinese central bank albeit having some semblance of flexibility. At the current rate of exchange, the RMB is undervalued. Since it is undervalued, foreign capital will want to enter China in the form of foreigners buying up the RMB. If the RMB is a freely floating currency, the demand for it by foreigners will bid up its price, which will reduce its demand as it becomes more expensive. Conversely, as its price rose, domestic sellers of RMB will sell down its price. Finally, a market equilibrium price will be reached where the quantity supplied will meet its quantity demanded. Since the RMB?s undervalued exchange rate is still barred by the Chinese central bank from rising, foreign demand will exceed its domestic supply. So, the question is: where is the RMB going to come from? In the absence of capital
controls freedom, the only choice the Chinese central bank has is to print RMB to maintain the undervalued exchange rate. Now, with foreigners armed with freshly printed RMB, they bided up the prices of Chinese assets, including stocks and properties. In the case of Shanghai, real estate prices had reached dangerously bubbled prices. As those newly printed money permeate its way into the rest of the Chinese economy, the result is price inflation. We are hearing reports from the grassroots level that prices of many things (including everyday goods and foodstuffs) in Shanghai are increasing.
Lately (as we mentioned before in Are you being ripped off by fund managers?), we are not keen in handing our hard-earned wealth into the managed fund that is sinking more money into the massive pool of raging liquidity in the Chinese economy. There are better alternatives to take part in the growth of China than to join in the bubble.