What is the real reason behind Chinese inflation?

China's State Council has said the government will introduce a property tax in two Chinese cities to tame inflation and prevent a possible real estate bubble.

The newly proposed taxes will be imposed in Shanghai and Chongqing on a trial basis. It's impossible for housing prices to fall overnight because of the property tax, but it will help to curb speculation in the housing market, said Chongqing mayor Huang Qifan.

The People’s Bank of China (PBOC) has hiked reserve rates for banks seven times in the past 12 months and hiked interest rates twice since October in a bid to rein in inflation.

REAL CAUSE OF CHINESE INFLATION

There are experts who say China cannot escape the inflationary spiral as long as it keeps it currency, yuan, pegged to the U.S. dollar. The more strength the Chinese economy gains with each passing day, which it does, the weaker the American economy becomes, making it ever more impossible for China to keep the cost of pegging the currency to dollar at a comfortable level.

As China’s economy gains strength, and the American economy weakens, the cost and difficulty of maintaining the peg become ever greater, and eventually outweigh the benefits that the policy supposedly delivers to China, Peter Schiff wrote in Daily Markets.

HOW DOLLAR PEG BOOSTS INFLATION

China maintains yuan's peg to the dollar by continually purchasing dollars in the open market, which means that China has to buy more ad more dollars as the U.S. currency gets weaker. And here is the role of the U.S. Federal Reserve in exacerbating Beijing's concerns.

The Fed's asset purchase program named quantitative easing is a constant thorn on China's side as it pumps in newly printed money into the market, thereby weakening the dollar. Federal Reserve is pulling out all the stops to create inflation and push down the dollar, Beijing’s task becomes nearly impossible, Schiff wrote.

China's plight can be gauged from the latest figures of its foreign exchange holdings.

The country's forex reserves shot up to a record $2.85 trillion in the fourth quarter of the last year. And the fact that most of this is held in U.S. dollars is important. Schiff puts in perspective the giant size of Beijing forex holding by pointing out that this amount accounts for a staggering 49 percent of China’s annual gross domestic product.

PRINTING MORE YUAN

What it means for China is that it has to print more yuan to buy these dollars and keep the peg in place. In essence, China is adopting the Fed’s expansionary monetary policy, he says.

However, ironically, when the largest economies in the world are doing more or less the same thing, it's only China that takes the hit in monetary terms, explains Schiff. This is because the newly printed U.S. dollars are exported to China when Americans buy goods imported from China, while the new Chinese money gets stuck in the domestic system, worsening inflation.

In the U.S. the inflationary impact of such a strategy is mitigated by our ability to export paper dollars in exchange for inexpensive Chinese imports. Although prices are rising here, they are not rising nearly as much as they would if we had to spend all this newly printed money on domestically produced goods. The big problem for China is that, unlike the U.S., the newly printed yuan are not exported, but remain in China bidding up consumer prices.