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By Scott Boyd

On February 8th, the People’s Bank of China raised the one-year lending rate twenty-five basis points to 6.06%. This marked the third rate increase in four months and most observers believe more interest rates hikes will be necessary for China to keep a lid on inflation.

The latest figures from China’s Statistics Bureau indicate that consumer prices jumped 4.9% in January compared to the same month one year ago. The actual result was less than the expected 5.3% but January’s outcome keeps intact a long string of monthly price increases, underscoring the risk of inflation in the Chinese economy.

In addition to raising rates further in the coming months, China’s monetary authority will likely continue the trend of forcing lending institutions to increase the percentage of funds to be held in reserve. This effectively removes liquidity from the money supply, leaving financial institutions with a smaller pool from which to lend to businesses and consumers. Rampant property speculation for instance has helped fuel a property bubble. In light of the Japanese and more recent American experience with property bubbles, authorities in China have good reason for concern.

Along with surging property values, a dramatic jump in food prices is forcing the government to take more decisive action. Authorities have even resorted to selling food reserves to augment supplies in an attempt to stem the pace of price increases. Officials are also taking sterner actions to target hoarding and other actions artificially boosting the cost to purchase these basic essentials.

Naturally, as prices continue to climb, pressure is building for salaries to also rise to help consumers bridge the growing inflation gap. The potential spillover effect could have serious implications for China’s all-important export sector.

China was able to position itself as one of the planet’s leading exporters by taking advantage of its abundant and – compared to most other countries – inexpensive workforce to produce goods at a lower cost than the traditional manufacturing centers. However, this advantage could be diminished if salaries are pushed higher to offset rising domestic prices.

Does China’s Inflation pose a threat to Global Recovery?

One thing lost in this discussion perhaps is how China’s inflation struggles could impact the global recovery. With the Eurozone lurching from one crisis to the next and the U.S. economy recovering at a much slower pace than following previous recessions, China is being heralded as the driving force to lead the greater global recovery.

But what if China’s internal problems worsen and it falls short of these expectations?

China’s central bank recently warned of the potential for this very scenario. As major economies in the West (read, the markets for China’s exports) abandon spending programs originally implemented to combat the recession, demand for imports from China could decline. Should China also be forced at the same time to tighten monetary policy to hold the inflationary tide, the combined impact could seriously impede China’s adopted role of the “engine” of the recovery.

Disclosure: None

Source: China's Inflation Could Threaten the Global Recovery