China has been suffering inflationary pressure from loose US monetary policy via the pegged exchange rate, and the country is now taking the steps I've been predicting to tighten domestic policy such as hiking the bank reserve ratio and restricting capital raising in the sectors with the greatest overinvestment, such as cement. As of yet, interest rates haven't been raised, as has been the case across the region from Australia to India. The problem is that if China raises rates well in advance of the US, it risks attracting further ‘hot money’ capital inflows, exacerbating the asset price risks. One answer is to revalue the RMB substantially and the issue is whether it takes the form of a gradual or one-off appreciation; circumstances increasingly suggest the latter.

A rise in imported commodity prices in 2010, particularly of food, will likely force the issue (see inflation chart below). Chinese M1 money supply growth was growing at 35% y/y at the end of 2009, but has turned negative in January; it's the single most important driver of CPI inflation, boosting prices with a lag of six to nine months, and has exceeded broader M2 since mid 2009. Proxy measures of inflation expectations, such as the difference between demand and time deposits, look to be rising as local asset prices have boomed. Acceleration in Chinese CPI inflation to around 5% by mid-2010 is likely and 6-7% by year-end if excess liquidity hasn’t been drained by then. While tightening moves, in addition to current administrative measures limiting credit growth/investment, will probably take the form of further rises in reserve requirements and interest rate hike, an attractive alternative means of curtailing the nascent asset bubbles and at the same time rebalance the economy, is to revalue.