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Too Much Money? "Cross-Eyed" Investors Approve!

"Red Hot" That's how China's official news agency described the nation's economic performance in the first quarter of the year. And, in case you hadn't heard, the Chinese economy beat all expectations, growing by a world-beating 9.7 percent compared to the same quarter a year ago.

Western investors will have to get used to seeing double. While Europe and the U.S. struggle with stagnant growth, high unemployment and dangerous debt levels, China faces the exactly opposite problems.

Western economies need more liquidity and growth. But China has been struggling to cool down its red hot economy and has had only limited success.

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The immediate danger facing Beijing is runaway inflation. Consumer prices rose 5.4 percent in March from a year ago. That's a 32-month high. It's also well above the official target of four percent.

Part of the problem is too much money. Economists like to call it "excess liquidity", but whatever you call it, the story is the same. There is too much money chasing too few goods. That's a classic definition of inflation.

China's broad measure of money supply (M2) covers cash in circulation and all deposits. In the first quarter of 2011, China's M2 increased by a mind-boggling 16.6 percent year-over-year.

China's banks are pouring money into the system. New yuan loans increased to 679 billion yuan ($104 billion) in March from 536 billion yuan in February. That's a whopping 26 percent increase in bank loan outflow in a single month. The effects of China's lending surge are easy to see in a one-year graph, which shows inflation more than doubling in a single year.

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Say what you will about centrally-planned economies but they do have the ability to act quickly. Over the weekend China's central bank raised reserve ratios by a hefty half a point. That boosts the amount of cash that the biggest banks must hold in reserve to back up their loans to a remarkable 20.5 percent.

And there's much more to come. The bank's governor warns that there's no absolute limit to how high the reserve limit might go in the effort to mop up excess liquidity. Two weeks ago interest rates were raised and now even more rate increases are now expected.

Beijing's tightening measures are not expected to end before the third quarter of the year because all the key economic indicators have exceeded expectations. Lu Zhengwei, chief economist with Industrial Bank told Xinhua, "Reserve ratios for banks are likely to be raised again, probably within two weeks. And one or two further rises in interest rates are likely before the end of the second quarter."

China's last interest rate increase lifted one-year borrowing costs to 6.31 percent and deposit rates to 3.25 percent. Contrast that with U.S. and Japanese lending rates which are near zero.

Good News, Bad News

Goldman Sachs is predicting a bright future for Chinese stock markets despite the struggle against inflation and rising interest rates. The U.S. investment giant expects the Shanghai-Shenzhen 300 Index to hit 3,500 points at the end of the second quarter. The index may even hit 4,000 points by the end of the year, Goldman says.

The fact is that many investors are impressed by China's relatively quick and tough action on the economy. Shanghai's benchmark stock index rose more than 8 percent in the first three months of the year.

Shanghai Composite Index: Three-Month Performance

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Shanghai's strong rise stands in sharp contrast to a decline of 2 percent in the MSCI Asia Pacific Index. That index includes many of China's trading partners in the Pacific basin.

Currently, the greatest danger facing the Chinese economy is that it could follow the boom and bust cycle which has plagued so many emerging nations. But so far the investment community has demonstrated that it believes China's declaration that controlling inflation is an "urgent and top" priority.

Food prices are still a key problem. Accounting for a third of the consumer price index, food costs surged 11 percent year on year. Beijing is appealing to major vendors to limit further price increases. Housing costs jumped 6.5 percent, and the government has been scrambling for the past year to implement new measures to control the real estate bubble.

Most unexpected, Beijing has signaled that it may allow further increases in the value of the yuan. With a more valuable currency, China could reduce the soaring costs of imported commodities.

Even with these tough measures, China faces major risks. Relatively high interest rates and a soaring currency could attract heavy flows of so-called "hot money" from investors abroad looking for quick gains. That could aggravate the inflationary spiral.

There's no minimizing the fact that China faces huge challenges. But give the mandarins in Beijing credit for coming to grips with their fiscal challenges. So far, that's a lot better than Washington's politicians have been able to manage in dealing with America's huge debt crisis.

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