Food and Fuel price Inflation in China has accelerated to 2.7%, creating a difficult situation for China's central planners. Normally, inflationary and deflationary pressures will lead to a central bank either injecting money into an economy to spur additional spending, or pulling money out of the economy to help control prices. China's problem is that it has economic forces in conflict, which makes it incredibly difficult to develop a viable economic solution.
High levels of investment led to concerns that the Chinese economy could become overheated. China responded to concerns about skyrocketing real-estate values by tightening fiscal policy, and is currently in the midst of a credit crunch, which has led some Chinese banks to advise foreign customers to be cautious with how they manage liquid capital in the Chinese market. Even with limits on Forex trading, a shortage of liquid capital may drive up the yuan versus foreign currencies. Allowing the yuan to appreciate could help to stabilize food, fuel and real-estate prices in the country, but there's a catch.
Yuan appreciation could limit the price competitiveness of Chinese manufacturers at a time when Chinese manufacturing indexes are showing slower than expected growth. With manufacturing costs in China already rising, currency appreciation could lead to reduced U.S. and European orders for consumer goods, and it's not certain that reduced food and fuel prices for Chinese consumers will spur enough of an increase in domestic consumption to offset those falling foreign orders. Declining orders could also limit employment opportunities for workers, which would attenuate the ability of Chinese consumers to engage in the kind of spending necessary to support their economy. Also, given China's recent housing boom, allowing the yuan to rise too rapidly could create significant deflationary pressure in Real Estate markets, leaving many Chinese underwater on their mortgages.
China's inflation problem is complex in that there's no single approach that offers a satisfactory solution. Adding stimulus to the economy could fix some things but creates one set of problems, while tightening of fiscal policies fixes other things but creates a whole other set of problems. The country is caught between a giant ocean, and an impassable mountain range.
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